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96th Congress 1 COMMITTEE PRINT { „ Cof ^r,

1st Session / I Print 96— IFC3

REPORT

OF THE

SPECIAL STUDY OF THE
OPTIONS MARKETS

TO THE

SECURITIES AND EXCHANGE COMMISSION

December 22, 1978

Printed for the use of the
House Committee on Interstate and Foreign Commerce

U.S. GOVERNMENT PRINTING OFFICE
40-940 O WASHINGTON : 1979

For sale by the Superintendent <>f Documents, U.S. Government Printing Office
Washington, D.C. 20402

COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE

HARLEY O. STAGGERS,
JOHN D. DINGELL, Michigan
LIONEL VAN DEERLIN, California
JOHN M. MURPHY, New York
DAVID E. SATTERFIELD III, Virginia
BOB ECKHARDT, Texas
RICHARDSON PREYER, North Carolina
JAMES H. SCHEUER, New York
RICHARD L. OTTINGER. New York
HENRY A. WAXMAN, California
TIMOTHY E. WIRTH, Colorado
PHILIP R. SHARP, Indiana
JAMES J. FLORIO, New Jersey
ANTHONY TOBY MOFPETT, Connecticut
JIM SANTINI, Nevada
ANDREW MAGUIRE, New Jersey
MARTY RUSSO, Illinois
EDWARD J. MARKEY, Massachusetts
THOMAS A. LUKEN, Ohio
DOUG WALGREN, Pennsylvania
ALBERT GORE, Jr., Tennessee
BARBARA A. MIKULSKI, Maryland
RONALD M. MOTTL, Ohio
PHIL GRAMM, Texas
AL SWIFT, Washington
MICKEY LELAND, Texas
RICHARD C. SHELBY, Alabama

West Virginia, Chairman
SAMUEL L. DEVINE, Ohio
JAMES T. BROYHILL North Carolina
TIM LEE CARTER, Kentucky
CLARENCE J. BROWN, Ohio
JAMES M. COLLINS, Texas
NORMAN F. LENT, New York
EDWARD R. MADIGAN, Illinois
CARLOS J. MOORHEAD, California
MATTHEW J. RINALDO, New Jersey
DAVE STOCKMAN, Michigan
MARC L. MARKS, Pennsylvania
TOM CORCORAN, Illinois
GARY A. LEE, New York
TOM LOEFFLER, Texas
WILLIAM E. DANNEMEYER, California

W. E. Williamson, Chief Clerk and Staff Director

Kenneth J. Painter, First Assistant Clerk

Eleanor A. Dinkins, Assistant Clerk

William L. Burns, Printing Editor

(ID

LETTER OF TRANSMITTAL

SECURITIES AND EXCHANGE COMMISSION

^--••^>;

WASHINGTON, D.C. 20549

OFFICE OF
THE CHAIRMAN

February 15, 1979

The Honorable James Scheuer
U. S. House of Representatives
Washington, D. C. 20515

Dear Congressman Scheuer:

I am pleased to transmit herewith The
Report of the Commission's staff's Special
Study of the Options Markets.

\M. Williams
fairman

(HI)

Digitized by the Internet Archive
in 2013

http://archive.org/details/respecialsOOunit

Special Study

of the

Options Markets

SECURITIES AND EXCHANGE COMMISSION
Washington. D.C. 20549

December 22, 1978

To the Chairman

and Members of the Securities and Exchange Commission

It is an honor to transmit to the Commission the Report of the
Special Studv of the Oct ions Markets. The Report describes the find-
ings and recommendations of the Options Study in response to the
Commission's directive set forth in its public release of October 1977. */
The Commission specifically directed the Options Studv to investigate
and studv the listed options markets to determine thu ability of self-
renulatory organizations, including national securities exchanges and
the National Association of Securities Dealers, Inc., to carry out their
requlatorv responsibilities to assure that listed options trading is
occurrinq in a manner, and in an environment, which is consistent
with the maintenance of fair and orderly markets, the public interest,
the crotection of investors and the other objectives of the Securities
Exchanoe Act of 1934.

In oeneral , the Options Study found that options can provide use-
ful alternative investment strategies to those who understand the
complexities and risks of options trading. But, since regulatory
inadeouacies in the options markets have been found, the Options Study
is makina specific recommendations needed to improve the regulatory
framework within which listed options trading occurs and to increase
the ixotection of public customers.

The Report is divided into eight chapters. The Introduction includes
a summarv of the Options Study's conclusions and recommendations. Chapter
II describes some fundamental uses of options. Chapter III describes the
wavs that market professionals use listed options. Chapter TV describes
and evaluates the market surveillance systems of the self -regulatory
organizations. Chapter V discusses options selling practices. Chapter
VT analyzes the adeouacy of self-regulatory organization oversight
of broker-dealer firms. Chapter VTI describes financial regulation
in the options markets. Chapter VTII discusses certain market structure
issues that proposals to initiate new options trading programs have
raised .

*/ Securities Exchange Act Release No. 14056 (October 17, 1977).

(V)

While the best of the market surveillance techniques that have
been developed would provide a self-requlatory organization with a
aeneral ability to detect known improper trading patterns, the Options
Study found that numerous improvements must be made in this area to
maximize the effectiveness of self-regulatory organization surveillance.
First, the surveillance information available to each self-regulatory
organization must be improved. In addition, surveillance information
must be better shared among the self -regulatory organizations and
surveillance programs should be better coordinated. Further, each
self-renulatory organization must evaluate its own surveillance
proqram to assure that it is using the most sophisticated market
surveillance techniaues available. New and additional data also
need to be developed to relate options trading to underlying stock,
tradinq not only for current market surveillance purposes, but also
to study the patterns, relationships and effects of related stock
and options tradinq.

The Options Study found numerous instances of sales practices
abuses in which registered representatives told investors of possible
rewards they miaht expect from options without simultaneously warning i
them of the risks inherent to options trading. Often, inadequately
trained registered representatives recommended options strategies
to their customers which it is doubtful that the salesmen, much less
their customers, understood. The most prevalent source of sales
practice abuses appeared to occur in broker-dealer firms that
encouraoed or permitted their registered representatives to recommend
options trades to their customers before the firms had in place appro- \
nriate supervisory controls to protect their public customers.

Mthough the primary responsibility for assuring that options
participants are both informed and treated fairly rests with the
brokerage firms, the self-regulatory organizations are required to
see that these industry-wide standards are established and met by
their member firms. Serious shortcomings were found in the self-
requlatorv organizations' oversight programs to detect and prevent
sellinq practice abuses of their member firms. Representatives of
the self-renulatory organizations demonstrated to the Options Study
staff their awareness of many of these regulatory problems and their
willingness to seek solutions on a continuing basis. The Options Study
believes that its recommendations for improved internal controls
by brokerage firms, enforced by self-regulatory organization rules
and actively overseen by the Commission will protect investors from
many of the selling practices abuses currently found in the options
markets, while at the same time fostering better understanding of
the risks of options trading by public customers.

VII

The Ootions Study also found that in the area of oversight of
broker-dealer retail activities, as v«ll as market surveillance, there
was a need for greater cooperation and sharing of information among
the self-renulatory organizations to avoid present duplication of
activities and to substantially improve the effectiveness of the
combined requlatory efforts. In order to facilitate this cooperation,
representatives of the self-regulatory organizations formed a Self-
Reaulatorv Conference to consider ways in which to improve the
coordination of their activities and to share market surveillance
and other requlatory data. To be successful, this effort will require
the full cooperation of the self -regulatory organizations and the
suoDort and oarticipation of the Commission.

In aeneral', the recommendations of the Cptions Study call for action
by the self-regulatory organizations to improve their own procedures
and those of their member firms. Placing primary responsibility on the
self-requlatory orqanizations reflects the importance of self-regulation
in the requlatory oattern of the securities industry. If the self-
renulatory orqanizations do not act, the Options Study recommends that
alternative action should be taken by the Commission through its authority
over the self-regulatory organizations and through its own enforcement
rowers.

Fbr the most oart, the Ootions Study has used examples of actual
abuses to demonstrate the problems which its recommendations are expected
to correct. The Ootions Study has not generally mentioned firms or indi-
viduals bv name, nor has any attempt been made to quantify the extent of
the abuses. The goal of the Options Study has been to recommend improvements
where requlatorv lapses have permitted significant abuses to occur or where
additional abuses could occur if corrections are not made. VJhile some
recommendations may increase costs to the self-regulatory organizations and
broker-dealers, the Options Study has made every effort to develop the least
costly solutions and has sought means to reduce current duplicative regula-
torv efforts in some areas so as to offset increased efforts required in
other areas.

Throughout its work, the Options Study has been aided by the
cooperation of the self-regulatory organizations, the Securities
Industrv Association and broker-dealer firms. In many instances,
the Ootions Study imposed substantial extra burdens on both organiza-
tions and individuals. Without the assistance of a number of indi-
viduals who made their expertise freely available, the Options Study
could not have completed its task within the time period that the
Commission established. Except as otherwise noted, staff investiga-
tions were concluded by the end of August 1978, although an effort
has been made to take into consideration any subsequent improvements
reported bv the self-requlatory organizations.

VIII

In addition, durinq the period of the Options Study, a number
of improvements were made in the regulatory programs of the self-
reaulatorv orqanizations. Some of these improvements may have
been coincidental with the Options Study's work. Others, however,
mav have represented an acceleration of improvements that would
otherwise have occurred. Unouestionably, many improvements resulted
from the increased attention given to finding solutions to deficiencies
by both the securities industry and the Commission during the moratorium.

While much of the Report focuses on the deficiencies that were
found in the regulation of the options markets, credit must be given
to the self-regulatory orqanizations for the regulatory and surveillance
work that they have accomplished since listed options trading began
in 1973. Many recommendations of the Options Study are designed to
extend to all self-regulatory organizations techniques which were
developed and are already employed by one or more of the self-
requlatorv orqanizations.

In view of the scope and complexity of the matters covered in
the Report, the Options Study cannot be viewed as providing the
definitive answers to all of the questions which need to be answered.
In accordance with the Commission's directive to concentrate on
the regulatory aspects of the self-regulatory organizations, the
Options Study's recommendations are designed to be effective in the
options markets as they currently exist. Thus, in many respects, the
Options Studv is merely a beginning. Its efforts should be continued
as a part of a regular Commission program of oversight of the options
markets. Some of the Options Study's recommendations are designed
to continue this effort bv developing new sources of data so that
the Commission and self -regulatory organizations can examine potential
oroblems which the Options Study could not analyze because adequate,
usable data was not available.

The Ootions Study did not undertake a study of certain broader
issues. The Options Study, for example, did not undertake its own
broad economic studies of the effect of options on the trading in
the underlyinq stocks or on the capital raising functions of the
securities markets, but instead has referred to studies performed
bv others. As the options market matures, and as additional infor-
mation becomes available, further studies will be needed. The Options
Studv did not attempt to compare the specialist and competing marketmaking
svstems used by the options exchanges. Similarly, while the Options
Studv has made recommendations to improve the ability of those who
make markets on the floor of an exchange to use credit in their
marketmaking activities on terms more favorable than public customers,

it did not consider whether there should be changes in the present
system of credit regulation which might make such favorable treatment
unnecessary or inadvisable.

A concerted effort has been made to simplify the description
of the matters covered in the Report and to avoid technical jargon
and extensive references to rules and regulations and legal precedents.
Unfortunately, the complexity of the subject matter has prevented
us from meeting this goal consistently. The pronoun 'he,' rather
than other alternatives, has been employed throughout this Report
to avoid the awkward reference 'he/she'.

While the staff of the Options Study is responsible for the
Report's contents, it was aided greatly by other members of the
Commission's staff. It drew upon the time and resources of the
various Commission Divisions in Washington and upon all of the
Commission's Regional Offices. Much information, along with ideas
which form the core of the Options Study's recommendations, was
develoDed from these sources. A list of Commission staff personnel
who contributed to the Options Study appears at the end of this
letter under "Acknowledgments." Special mention, however, must
be made concerning the extensive and continuing support of Andrew M.
Klein, Sheldon Raopaport, and Kathryn B. McGrath of the Division of
Market Regulation, Stanley Sporkin, Wallace L. Timmeny, Theodore A.
Levine and Ira H. Pearce of the Division of Enforcement, and Ralph C.
Ferrara and Robert C. Pozen of the Office of the General Counsel.
The Options Study was organized and directed by Martin L. Budd until
June 16, 1978, when he resigned as Director for personal reasons.

Re>pec1^2lly submitted,
Richard L. Teberg f

Director

THE SPECIAL STUDY OF THE
OPTIONS MARKETS

Director :

Richard L. Teberg

Martin L. Budd (before June 19, 1978)

Chief Counsel: Martin Moskowitz

Senior Economic Advisor: Gene L. Finn

Assistant Director - Self Regulatory Systems: Van P. Carter

Assistant Director - Sales Practices: Thomas J. Loughran

Assistant Director - Trading Practices: Kenneth S. Spirer

Financial Regulation and Credit Specialist: Robert L. Smith

Special Counsel: Richard I. Weingarten

Special Assistant to the Director: Marianne K. Smythe

Staff Attorneys:

Lawrence R. Bardfeld Sanmy S. Knight

M. Blair Corkran, Jr. John E. Larouche

Ray J. Grzebielski Gary G. Lynch

Richard G. Ketchum Janet R. Zimmer

Senior Financial Analyst: Dennis G. Shea

Economic Liaison (until June, 1978): Richard J. Morrisey

Statistical Consultant: Robert H. Menke

Editorial Consultant: Lael Scott

Staff Assistant: Rhoda S. Clavan

Interns :
Brian Timken
William T.K. Dolan

Secretaries:

Den ice S. Dishman Rosalie C. Moyer

Cletha I. Francis Lorna Olsen

Gail D. Hogg Donna M. Phelps

Nora J. Huke Pamela M. Switzer

Valerie L. Krohn Sandra L. Washington

Susan E. Morrow

(XI)

XII

ACKNOWLEDGMENTS

The Options Study received assistance from numerous segments of
the Commission's staff. Regretably, it is not feasible to acknowledge
the contribution of each person individually. A special note of
appreciation is given, however, to the staffs of the following offices
and divisions and to the particular individuals noted below:

Headquarters Staff
Directorate of Economic and Policy Research Division of Market Regulation

Roger W. Spencer
Charles W. Bryson
Peter G. Martin
Ha jo Lamprecht
Johnathan L. Hunter
Eileen F. Whelan

Division of Corporation Finance

Richard H. Rowe
Mary E. T. Beach
J. Rowland Cook
Paul A. Bel v in
Timothy M. Harden

Division of Enforcement

Stanley Sporkin
Theodore A. Levine
Edward D. Herlihy
Ira H. Pearce
Richard V. Norell
Paul W. Bodor
Joseph Cella
Harold L. Hal pern
John F. Hartigan
Stanley B. Whit ten

Office of Consumer Affairs

Justin P. Klein

Office of Data Processing

John D. Adkins
Richard T. Redfearn

Office of Administrative Services

Richard J. Kanyan
James T. Willis

Andrew M. Klein
Sheldon Rappaport
Kathryn B. McGrath
Lloyd H. Feller
Douglas S. Scarf f
Mark 0. Fitterman
Roger D. Blanc
Nelson S. Kibler
Harry S. Day
Harry Melamed
Michael P. Maloney
Jessica Licker Osborn
Robert J. Bretz
Leonard L. Unger
Gene E. Carasick
Herbert F. Brooks, Jr.
Therese M. Haberle
Marc L. Weinberg
Barbara E. Polonsky
William J. Finegan

Office of the General Counsel

Ralph C. Ferrara
Robert C. Pozen
John P. Wheeler
Eric D. Roiter
Theodore Bloch

Office of Public Affairs

Andrew L. Rothman

Office of the Secretary

George A. Fitzsimmons
Shirley E. Hollis
Charlene C. Derge
Raymond J. Kramer

Office of the Executive Director

Benjamin Milk
George G. Kundahl
James A. Clarkson, III

XIII

Atlanta

Regional and Branch Offices
Denver

Jule B. Greene
George M. Callahan
John T. E. Van Deusen
Kenneth E. Newman

Robert H. Davenport
Harold M. Golz

Fort Worth

Boston

Willis H. Riccio
Arthur A.. Carr
Raymond D. Vaillancourt
Thomas P. Kehoe
Katherine W. Keane

Chicago

William D. Goldsberry
William M. Hegan
Joan M. Fleming
Ronald P. Kane
Michael J. O'Rourke
John R. Brissman
Ellen E. Douglass
Steven D. Edelson
Diane Fischer
Joyce Lynch
David M. Matteson
Peter B. Shaeffer

New York

William D. Moran
Edwin H. Nordlinger
Sheldon G. Kanoff
Carmine L. Asselta
Michael T. Gregg
Paul S. Maco
Bernard Schwartz

^Philadelphia

Thomas H. Monahan
Sheldon J. Sandler
Daniel F. McAuliffe
John A. Galante

* Branch Office

Michael J. Stewart
Wayne M. Secore
Gordon R. Cox
James H. Perry
Mary Lou Felsman

Los Angeles

Gerald E. Boltz
Hillel Conn
Israel Mattatia
Raoul McDuff
Joel M. Bolten

'Miami

William Nortman
Charles C. Harper
Charles D. Hochmuth

Seattle

Jack H. Bookey
C. Arnold Taylor
John R. McNeall

Washington

Paul F. Leonard
Edward A. Kwalwasser
Richard A. Mangini
Robert W. Martinson
Louis A. Perrotto

rSan Francisco

Leonard H. Rossen
Steven N. Mochtinger
Harry M. Jones
Ming Suen

GLOSSARY

It is hoped that the following brief explanations of various terms
and acronyms used in the Option Study's report will be helpful, particularly
to the non-professional reader, in understanding the text of the report.
Of course, no attempt has been made here to formulate legal definitions.

Account Statements

Brokerage firm statements sent periodically
to customers, usually itemizing all securities
held in an account and the cash balance.

At-the-money

When the option's exercise price is the same
as the current trading price of the underlying
stock.

AMEX

American Stock Exchange, Inc., on which stocks
and listed stock options are traded.

Arbitrage
Audit Trail

Trading to take advantage of a perceived temporary
pricing disparity between two securities.

The physical record of trading information identifying,
for example, the brokers participating in each
transaction, the firms clearing the trade, the
terms and time of the trade and, ultimately
and when applicable, the customers involved.

Bearish

An investor's attitude when he believes the market
or a particular security's price will decline.

Bear Market

A market in which the general trend of securities
prices is down.

Bear Vertical
Soread

A hedged strategy employed when an investor expects
a decline in the security price but at the same
time seeks to limit the potential loss if he is
wrong. This spread requires the simultaneous
purchase and sale of options of the same class
and expiration date but different strike prices —
e.g., if call options are "spread," the purchased
option must have a higher exercise price than
the sold option (for a higher premium on the
sale) .

Beta

A measure of a stock's sensitivity to the movement
of the general market.

(XV)

XVI

Bid/Ask

The market quotation for a stock or option.
A bid is the price at which a potential buyer
is willing to buy. An ask is the price at which
a potential seller is willing to sell i.e. , his
asking price.

Block Trade

A single transaction involving a large number
of shares or option contracts. The NYSE defines
a block as a transaction of 10,000 shares or
more.

Broker-Dealer

A securities firm, generally one that does
business on behalf of customers (as a broker)
and for its own account (as a dealer).

Bullish

An investor's attitude when he believes the
general market or a particular security's
price will advance.

Bull Market

A market in which the general trend of securities
prices is up.

Bull Vertical
Spread

A hedged strategy used when an investor expects
that the price of a security will go up but at
the same time seeks to limit his potential
loss should his judgment be in error. This
strategy involves the simultaneous purchase
and sale of options of the same class and
expiration date but different strike prices —
e.g. , if call options are "spread," the purchased
option must have a lower exercise price than
the sold option.

Butterfly Spread : An options position involving the simultaneous purchase
and sale of options in the same class, with the same
expiration date, so that for every two options
sold, two options-one with a higher exercise price
and one with a lower exercise price-are bought.

Call Option

A contract giving the holder the right to
buy a specified number of shares (usually
100) of the underlying stock at a specified
price within a specified period of time.

XVII

Called

Another term for "exercised" when the option
is a call. The writer of a call must deliver
the indicated underlying stock when tne option
is exercised or called.

Capping

Effecting stocK transactions shortly prior to an
options expiration date to depress or prevent

a rise in the price of a stock so that previously
written call options will expire worthless and
the premium received therefrom will be protected.

CBOE : Chicago Board Options Exchange.

Class of Options : Options contracts of the same type (put or call)
covering the same underlying security.

Clearing Firm : A broker-dealer member of the Options Clearing
Corporation (OCC) engaged in the business of
clearing, through OCC, listed options trans-
actions for its own account or on behalf of
other firms. Called a "marketmaker clearing
firm" when it clears for marketmakers .

Closing Purchase : A transaction in which an option writer terminates

his obligation by buying an option with the identical
terms as the option previously sold.

Closing Sale

A transaction in which the holder of an option
liquidates his position by selling an option
having the same terms as the option he previously
purchased .

Commissions

A fee charged each customer by his brokerage firm
for stock or options transactions made on his
behalf.

Compliance Programs:

Activities conducted by self -regulatory organizations
to detect and discipline violations of the Federal
securities laws and securities industry rules con-
cerning retail sales and certain other practices of
their member firms and employees. Broker-dealers
conduct similar programs respecting the activities
of their own sales personnel.

40-940 O - 79 - 2

XVIII

Conversion

Cover

Delta Factor

An arbitrage technique involving buying an underlying
stock, selling the related calls and buying puts
corresponding to the calls.

A writer's purchase of stock to deliver to the holder
when the holder exercises a call option and the writer
does not then own the stock he wrote the call on. Also,
to purchase options to eliminate a short options position.

The amount of change in an option's theoretical value
relative to small changes in the price of the underlying
stock over a short period.

Demand
Equity

The degree of investor interest in purchasing a security.

The net worth of an account, determined by subtracting
the market value of short security positions and
the debit balance (if any) from the market value
of long security positions and the credit balance
(if any). Equity represents ownership in the
account.

Equity Securities : Corporate securities, usually common stocks, which
represent ownership in the issuing corporations.

Excessive Trading : Transactions that do not have a valid investment
purpose but, instead, are made for the purpose
of generating commissions for the salesman or
brokerage firm. Often called "churning."

Exercise Price
(Striking Price)

Expiration Date

Fictitious Trades

Tne price per share at which the option buyer may
buy, in the case of call, or sell, in the case of
a put, 100 shares of the underlying stock.

The date on which an options contract expires. The
date is listed by month only (e.g. January, April,
July) and refers to the Saturday following the
third Friday of the month.

Reports of transactions submitted to a price re-
porting system of an exchange but which, in
fact, did not occur.

XIX

Firm Proprietary
Trading

Frontrunning

Haircut

Hedging

Holder
In-the-Money

Initial Margin

Securities transactions entered into by a broker-
dealer for its own account.

The practice of effecting an options transaction based
upon non-public information regarding an impending
block transaction in the underlying stock, in order
to obtain a profit when the options market adjusts
to the price at which the block trades.

An amount deducted from a broker-dealer's net worth
in determining its net capital. It is a percentage
of the value of a broker-dealer's marketable secu-
rities and is designed to provide a cushion of capital
in the event of adverse price movement. The percentage
amounts generally range from 1/8 of a percent for
commerical paper to 30 percent for common stock.

Lessening a risk of loss by, for example, offsetting
a long position in one security with a short position
in a related security, or vice-versa.

Person who purchases an option, also called a buyer.

When the exercise price for a call is lower than the
current market price of its underlying stock;
or for a put, when the exercise price is higher
than the stock's current market price.

A deposit a customer must make in accordance with
Regulation T as a result of a securities transaction.
Naked call writers, for instance, must deposit cash
or margin securities whose loan value equals at
least 30% of the value of the underlying securities,
less the proceeds of the option sale.

Institutional
Investors

An investment company, bank, insurance company,
endowment, pension fund or other organization
which has substantial funds committed to securities
investments.

Intrinsic Value : The amount by which the current market price of the
(of an option) underlying stock exceeds the exercise price of a call
option, or is less than the exercise price of a put.

Listed Option

An option traded on a national securities exchange.

Long Option
Position

Maintenance Margin

Marketmaker

Mini-manipulation

MSE
NASD

The number of option contracts of a particular
option series held in an individual account or
group of accounts.

The minimum amount of margin (equity) that must be
maintained in a general account as required by
exchange or association rules.

A dealer who holds himself out as being willing
to buy and sell securities for his own account
on a regular or continuous basis. On the options
exchanges, certain rules are designed to require
such market participation for members dealing on
their floors, and such members may be called
competitive marketmakers , registered options
traders, etc. See "Specialist" below.

An attempt to influence, over a relatively small
range, the price movement in a stock to benefit
a previously established. opt ions position.

Midwest Stock Exchange.

National Association of Securities Dealers, Inc.,
a self-regulatory organization of broker-dealer
members involved in the over-the-counter securities
markets .

Naked (Uncovered)
Option Writing

An option writing position collateralized by cash
or by securities unrelated to those on which
the stock option is written.

Near Term
NYSE

Close to expiration.

New York Stock Exchange, on which most of the stocks
underlying listed options are traded.

OCC

Options Clearing Corporation.

XXI

OCC Prospectus : The required disclosure document for listed options.
Exchange rules require that a current prospectus
be provided to options customers at or prior
to the time their accounts are approved for ■
options trading.

Open Interest

The number of listed options contracts of a class
outstanding at any given time.

Opening Purchase
Transaction

A transaction in which an investor becomes
the holder of an option.

Opening Sale
Transaction

A transaction in which an investor becomes
obligated as the writer of an option.

Option

A contract which allows the buyer, by exercise,
to buy or sell stock (usually in 100-share units)
at a certain price (exercise or striking price)
over a certain period of time, regardless of how
high or low the price of the stock (the underlying
security) moves during that time.

Options (OTC)

Non-listed put and call options whose expiration dates
and exercise prices are not standardized; OTC options
are not cleared or guaranteed by the Options Clearing
Corporation (OCC).

Out-of-tne-
Money

When the exercise price for a call is higher
than the current market price of the underlying
stock or, for puts, when the exercise price is
lower than the stock's price.

Parity
Pegging

When the premium (market value) of an option at
least equals its intrinsic value.

Eft stock transactions to prevent a decline
in ti. -rice of the stock so that previously written
put opt ns will expire worthless, thus protecting
premiums previously received.

XXII

Performance
Reports

Written materials used by sales personnel to present
to options customers the results of actual options
transactions, usually in the form of a profit and
loss statement.

PHLX

The stock exchange headquartered in Philadelphia
on which stocks and listed options are traded.

Position

Adjustments

Changes initiated by clearing member firms in their
customer, market maker or firm proprietary options
position records maintained by OCC.

Position Limits : Limits set upon the number of options contracts
relating to an underlying security which an
investor may own or control.

Prearranged Trades

Transactions on the floor of an exchange which
are effected pursuant to a prior agreement among
the parties. An order to buy or sell an option
is entered with the knowledge that another person
will enter an order of substantially the same
size, at substantially the same time, and at
substantially the same price. Two variations
are called "wash sales" and "trade reversals."

Premium

Professional
Traders

The money paid for an option contract by a buyer
and received by the option's writer. The premium
is kept by the writer whether or not the option
is exercised.

Persons who earn their livelihood from buying
and selling securities on the floor of an ex-
change, such as an institutional money manager,
or a dealer trading from off -floor, etc.

PSE

Public Customers

Pacific Stock Exchange. Listed options are traded
on the San Francisco floor of this exchange.

Persons who pay commissions to effect securities
transactions through broker-dealers, and who are
not professional traders.

XXIII

Put Option

A contract giving the purchaser the right to sell
a specified number of shares (usually 100) of
the underlying stock at a specified price within
a specified period of time.

Renistered
Representative

A salesperson employed by a brokerage firm who
handles customer accounts.

Regulation T

The Federal Reserve Board rule governing, among
other things, the amount of credit (if any)
that initially may be extended by a broker to
his customer on a securities transaction.

Restricted Options

An options series in which prohibitions on
opening purchase and sale transactions are in
effect.

Reverse Conversion

An arbitrage technique involving the short sale
of an underlying stock, the purchase of related
calls and the sale of puts corresponding to the
calls.

Registered Options
Principal ("ROP")

An employee of a broker-dealer firm who is
responsible for supervising the customer
options account activities. He is required
to pass a special qualifying examination in
options.

Seal pi na

An option marketmaking strategy involving the
purchase of options at the bid price and sale
at the asked price in order to earn the differential
or spread, sometimes referred to as the "jobber's
turn" .

Secondary Market : Provides for the selling and/or buying of
previously bought or sold options through
closing transactions.

Self -Ren ulatory
Conference

A series of meetings commenced in August, 1978,
attended by representatives of the self-regulatory
organizations to discuss issues raised by the
Options Study.

XXIV

Series

Options of the same class having the same
exercise price and expiration date.

Short Option
Position

The open position of the writer or seller of an
option.

Short Term

Of limited duration. All listed option trading is
generally referred to as short term because options
expire in a maximum of nine months.

SIAC

Securities Industry Automation Corp. An organization
jointly owned by the American Stock Exchange and
the New York Stock Exchange that acts as facilities
manager and data processor for various securities
related activities of the SRO's.

SIPC

Securities Investor Protection Corp. A non-profit
membership corporation established by Congress to
afford certain protection against financial loss
to customers of its members which fail. Its members,
with certain exceptions, are all registered brokers
or dealers.

Specialist

A member of a specialist exchange (e.g., Amex, NYSE),
as distinguished from a marketmaker exchange, who is
permitted to deal on the exchange floor for his own
account while at the same time effecting transactions
as broker for the accounts of others. For some
purposes, however, marketmakers are sometimes
referred to as specialists.

All specialists have certain obligations to maintain
fair and orderly markets. Among the benefits they
enjoy by virtue of their specialist status is special
margin treatment under the Federal Reserve Board
Regulations T and U.

Spread

The difference between one price and another (for
example, between the bid and the ask prices); or
an options position created by buying and selling
of different series of options of the same class.

SRO

Self-regulatory organization — includes the national
securities exchanges and the National Association
of Securities Dealers (NASD). Each is required
to regulate and oversee its broker-dealer member
firms and their employees.

XXV

Straddle

Striking Price
Suitability

A combination option position consisting of one
put and one call of the same class. Either option
is exercisable or salable separately and the exercise
prices and expiration dates are usually identical.

Also called exercise price,
an option is exercisable.

The price at which

Suitability is a concept designed to protect
customers by obligating brokerage firms and
registered representatives to recommend for a
customer only those securities transactions which
they reasonably believe are not unsuitable for the
customer in light of his financial situation and
needs.

Surveillance
Programs

The methods by which the self -regulatory organizations

detect trading practices that

may be inconsistent with the Securities Exchange

Act, the rules thereunder, and the rules of those

organizations.

Transactions Costs :

Expenses incurred in buying or selling securities,
the most important of which are commissions.

Uncovered (Naked) : A writer who does not own the underlying stock
Writer which is the subject of an option.

Underlying Stock : The stock suoject to being bought or sold upon
exercise of an option.

Upstairs Dealer
Firms

Worksheets

Securities dealers that initiate exchange trans-
actions from off the floor of the exchange.

Written materials used by sales personnel to
portray to customers the potential profits and
risks of proposed options transactions.

Writer

The seller of an option contract.

COX TENTS

Page

Letter of transmittal m

Digest of report v

The special study of the options markets staff list xn

Glossary xv

CHAPTER I— Introduction:

A. The growth of listed options trading 1

B. Effect or listed options trading on the securities industry 9

C. Studies of economic effects of listed options trading 12

D. Summary and conclusions of the options study 18

1. Self-regulatory organization systems 19

(a) Market surveillance 19

(1) American Stock Exchange surveillance in-

formation and audit trail 21

(2) New York Stock Exchange surveillance

information and audit trail 24

(3) Firm proprietary and customer trading in-

formation 25

(4) Options clearing corporation position ad-

justments 26

(5) The sharing of surveillance information

and the allocation of regulatory re-
sponsibility 27

(6) Investigation and enforcement 30

(b) Broker-dealer oversight 33

2. Trading practices 37

(a) Professional trading 38

(b) Position limits 40

3. Selling practices 43

(a) Customer protection 44

(1) The OCC prospectus 44

(2) Customer suitability 47

(3) Opening account statements 50

(b) Responsibilities of broker-dealer firms 52

(1) Qualification of registered representatives, .V2

(2) Supervision of registered representatives

and of customer accounts 54

(3) Recordkeeping and communications with

customers 56

(4) Exercise allocations 58

4. Financial structure 58

(a) The Commission's net capital rule 59

(1) Increase of deductions in computing net

capital 60

(2) Net capital deductions for marketmaker

clearing business 62

(3) Marketmaker minimum net capital 63

(4) Financial requirements of upstairs dealer

firms 64

(5) Marketmakers that are OCC members.. _ 66

(b) Options specialist stock credit 67

(1) Stock hedge 68

(2) Limit on stock qualifying for specialist

stock credit 71

5. Market structure 72

(xxvn)

XXVIII

CHAPTER II— Fundamentals of Exchange Traded Options:

A. Characteristics of options 73

1. Conventional OTC options compared to listed options 73

2. The options contract 76

3. Stock price considerations in listed options 82

4. Short-term character of options trading 83

5. Transaction costs 87

6. Options pricing models 90

7. Examples of the effect of options contracts 96

(a) Call option 97

(b) Put option 99

B. Principal strategies 106

1. Introduction 106

2. Ten basic strategies 107

3. Survey of investor use of option strategies 114

4. Writing options for premiums 117

Exhibit I: The relationship between puts, calls, starddles and

stocks 121

CHAPTER III— The Use of Options By Professional Traders:

Introduction 125

1. On floor market participants '. 129

(a) Obligations 129

(b) Privileges 132

(d) Stock/options trading strategies 138

2. Upstairs firms 144

(a) Advantages enjoyed by upstairs firms 144

(b) Arbitrage trading 147

(1) Conversion and reverse conversion arbitrage 148

(a) Conversion arbitrage 149

(b) Reverse conversion arbitrage 151

(2) Hedged short selling 153

(3) Merger or exchange offer arbitrage 155

(4) Discount options arbitrage 158

c. Block trading 159

d. Creation of synthetic puts 163

3. Institutional investors 165

4. Specific trading abuses 169

(a) Fictitious trades 169

(b) Prearranged trading . 170

(d) Stock option manipulation 173

(1) Minimanipulation 173

(2) Capping and pegging 175

(3) Statutory prohibition of manipulation 176

(4) Problems of proof and the need for data 178

(e) Front-running 183

5. Trading rules 189

(a) Position limit rules 189

(b) Restricted options rules 193

XXIX

CHAPTER IV — Self-Regulatory Organization Surveillance of the Stand-
ardized Options Markets:

I. Introduction 197

II. Methodology 201

III. Surveillance infoimation 203

1. The sources of surveillance information 203

2. The organization of capture of suiveillance information. _ 208

(a) Transaction information 208

(b) Clearing information 212

3. Conclusions and recommendations 219

a. Surveillance infoimation 219

(1) AMEX surveillance information and
audit trail 220

(2) NYSE surveillance information and
audit trail 223

(3) Stock market reconstruction 230

(4) Firm proprietary and customer trading
identification 233

(5) Customei account identification 236

(6) OCC position adjustments 238

b. Surveillance techniques 243

( 1) Surveillance techniques and surveillance
information 243

(2) The sharing of surveillance information
and the allocation of regulatory respon-
sibility 244

(3) Improving options exchange surveillance
techniques 252

(4) Uniform repotting requirements 253

IV. Investigation and enforcement 254

1. The CBOE and PSE 255

2. The PHLX 257

3. The AMEX 258

4. The MSE 263

Table 1 — Surveillance data Available 207

Table 2 — Comparison of surveillance data available to surveillance data

captured 218

Exhibits:

1. CBOE Market Data Retrieval Listing (MDR):

A. By Time 265

B. By Price 266

2. Amex options daily journal report 267

3. NYSE daily transaction journal 269

4. CBOE matched transaction listing (MTL) 270

5. NYSE daily reconciliation clearing sheets 271

6. OCC daily position report 273

7. Amex foim 958-C-. 274

8. PSE form OTR-1 275

9. Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self-Regulatory Conference, dated October 6,

1978 276

XXX

Appendix Exhibits*:

1. Trading procedures and trade matching operations of the AMEX,

CBOE, MSE, PHLX, PSE, and NYSE; surveillance techniques
of the AMEX, CBOE, MSE, PHLX, and PSE.

2. Sample inspection outline and inspection information request

(CBOE).

3. CBOE marketmaker minimanipulation and capping investiga-

tion (Case No. M 7145).

4. PSE expiration study.

5. CBOE capping investigation (complaint No. M 8018).

6. AMEX capping investigation.

7. AMEX capping investigation.

8. NYSE expiration study.

9. CBOE prearranged trading investigation (complaint No. M 8080).

10. AMEX prearranged trading investigation.

11. CBOE prearranged trading investigation (Case No. M 7052).

12. CBOE fictitious trading investigation (Case No. M 7061).

13. CBOE front-running investigation (Complaint No. M 8078).

14. AMEX front-running investigation.

15. PSE front-running investigation.

16. Inside information investigation.

17. AMEX inside information investigation.

18. CBOE position adjustment investigation (complaint No. M 8098).

19. CBOE position adjustment investigation (complaint No. M 7163).

20. Table A: Exchange surveillance parameters.
Table B: Summary of exchange personnel.
Table C: Exchange surveillance expenditures.
Table D: Options exchange cleared contract volume.

CHAPTER V— Options Selling Practices: page

Introduction 289

A. Registered representative qualification, preparation and motiva-

tion 296

B. Supervision of accounts 314

C. Suitability -336

D. Disclosure documents 369

E . Promoting options — general problems 384

F. Promoting options — specific methods 402

G. Promoting options — investment programs 425

H . Options trading in customer accounts 440

I. Exercise problems 477

CHAPTER VI— Self-Regulatory Organization Oversight of Retail Firms
and Their Associated Persons:

I. Introduction 487

II. An Overview of SRO compliance programs 492

A. Monitoring programs 492

1. Employment and termination of registered re-

presentatives 493

2. Customer complaints .. 494

3. Advertising 494

4. Financial responsibility early warning systems 496

5. Credit monitoring 496

B. Cause examinations 497

C. Routine examinations 498

D. Disciplinary actions 501

*These Appendix Exhibits are available publicly in the Commission's Public Reference Room and,
therefore are not published as a part of this report.

XXXI

CHAPTER VI— Continued page

III. Obtaining compliance information 502

A. Public customers

B. SROs

1. Sharing of information

2. Coordination of compliance programs 1 516

C. Government agencies 518

D. Retail firms 520

1. Accessibility of customer complaints and ac-

count information 520

2. Reporting requirements 524

IV. Deficiencies in SRO examinations 530

A. Limited scope of examinations 530

B'. Poor selection of accounts for review

C. Inadequate depth of account examinations 540

D. Reliance on firms for assistance 544

E. Failure to resolve disputed issues of fact 547

F. Inadequate resources

V. Remedial action- 550

A. Extent of disciplinary proceeding 551

B. Use of informal sanctions 554

C. Reasons for inadequate sanctions — restrictive SRO

policies 561

D. SRO internal supervision 564

E. Restitution as a sanction

F. SRO disciplinary proceedings: a final note

VI. The need for minimum SRO compliance standards 567

Table I — Number of options related sales practice (or capital/sales practice)

examinations conducted by SROs 500

Table II — Summary of SRO examination and disciplinary action as to

firmXYZ _ 509

Table III — Summary of SRO information on selected securities salesmen 512

Table IV — Selected comparison of complaints reported to NYSE and

complaints received by two N YSE member firms in 1977 525

Table V — Summary of types of options related violations detected by
SROs in their 1977 sales practices and capital/sales practice examina-
tions of firms with options commission income in excess of S1,000,000__ 539

Table VI — Options related sales practice disciplinary actions brought by

the SROs as of March 1978 7^1

Table VII — Summary of disciplinary action by an SRO against firm ABC— _ ')'>")

Exhibits:

Options study questionnaire set to the options exchanges (App. A*).
Options study questionnaire sent to the NYSE (App. B*).
Options study questionnaire sent to the NASD (App. C*).
Summary of SRO options related examinations ancl investigations of

firm DEF for 1973-1978 (App. D) 570

Letter to Richard Tebergfrom the Self-Regulatory Conference (App.

E) ;

L itter from Van P. Carter to Gerald Folev (NASD) (Oct. 11, 1978)
(App. F) J 590

Summary of statistics relating to SRO routine sales practice examina-
tions (App. G) 004

Summary of SRO financial resources (App. H) 611

*These appendix exhibits are available publicly in the Commission's public reference room and, there-
fore, are not published as a part of this report.

XXXII

CHAPTER VII— Financial Regulation in the Options Markets:

1 Page

Introduction 615

Broker-dealer financial regulation 620

1. The Securities Investor Protection Act 620

2. Commission action 621

(a) Commission's customer protection rule 621

(b) Commission's uniform net capital rule 622

3. The Options Clearing Corporation financial rules 625

(a) OCC clearing members 625

(b) OCC member capital requirements. 628

(d) OCC settlement requirements 632

(e) OCC clearing fund 639

4. Study of the financial integrity of the options markets 640

(a) Margin and clearing fund deposits 643

(b) Market makers and market maker clearing firms 646

.">. Recommended changes to the net capital rule 649

(a) Concentrated positions 649

(b) Short positions in near or at-the-money options 652

(d) Market maker minimum net capital 657

(e) OCC members and their affiliates that are market

makers 661

(f) Immediate charges to carrying firm under the net

capital rule 663

(g) Conversion — reverse conversion positions. 665

(h) Financial requirements of upstairs dealer firms 667

Options specialist and stock credit 674

1. Specialist accounts 676

2. Good faith credit 678

3. Free-riding and bona fide hedging 680

4. Options pricing formula 684

5. Limit on stock qualifing for specialist stock credit 691

Exhibits:

1. SEC reporting forms X-17A-5 part II and part II A 693

2. Options study letter to OCC, dated May 5, 1978 and attachment. 695

3. Options study letters to AMEX, BSE, CBOE, MSE, NASD,

NYSE, PHLX, and PSE, dated June 7, June 16, and June 27,

1978 and attachments 705

4. Options study financial and operational questionnaire:

(a) Form A 763

(b) Form B 768

5. Options floor participant equity:

(a) All options exchanges 769

(b) AMEX 770

(d) MSE 772

(e) PSE 77 3

(f) PHLX — 774

6. Options floor particpiant equity requirements 775

7. Letter from the staff of the Federal Reserve Board, dated Decem-

ber 5, 1978 776

CHAPTER VIII— Issues of Structure in the Standardized Option Markets:

I . Introduction 779

II. The statutory standards 782

A. A national market system 782

1. A national market system and SEC authority.- 782

2. Objective's of a national market system 786

3. The elimination of unnecessary regulatory re-

strictions 790

4. Communication among and dissemination of in-

formation about securities markets 792

5. Multiple trading 795

B. The basic statutory goals 797

XXXIII

CHAPTER VIII— Continued page

III. Multipl ■ trading of stan lardiz ;d option- 800

A. Th • effects of multiple trading of standardized options ._ 807

1. The effects <>f multipl" trading on the quality of

market- for multiply traded option class is 809

2. Competition among market centers 824

B. Market fragmentation : 827

1. The extent of market fragmentation for multiply

traded option classes 828

2. Brokerage fiim order routing decisions in the

fragmented market environment 830

3. Market fragmentation, option pricing, and order

interaction 839

C. Conclusions 843

1. The multiple trading of standardized options and

the Exchange Act 843

2. The multiple trading experience 84G

3. Market fragmentation and the Exchange Act 849

4. Primary market designations and automated

order routing 853

"). The multiple trading of standardized options and
recent initiatives toward the development of a
national market system 864

IV. The integration of trading of options and their underlying

Securities 870

A. The general considerations 876

1. The quality of markets 877

2. The regulatory concerns 880

(a) Market information and competitive ad-

vantage 880

(b) Manipulation and other improper trad-

ing practices 885

ligations 892

(d) Market surveillance 896

3. The extent of integration 900

4. Characteiistics of the exchange 903

(a) Primary and secondary exchanges 904

(b) The marketmaking svstems 907

B. Conclusions 1 916

1. The gradual approach 916

2. Principles of general applicability and the statu-

tory standards 917

3. The principles applied 920

V. An over-the-counter market for standardized options 926

A. Standardized options and underlying securities traded

exclusively in the over-the-counter markets 930

1. The absence of real-time last sale reporting for

underlying securities traded exclusively in the
over-the-counter markets 933

2. Representative bid and ask quotations for secu-

rities traded in the over-the-counter markets, _ 938

B. Trading exchange listed options in the over-the-counter

markets 945

1. Fragmentation and internalization 946

2. Market information and competitive advantages

of over-the-counter marketmakers 948

3. Over-the-counter markets and a national market

system which would include standardized
options 951

C. The integration of trading of options and their underlying

securities in the over-the-counter markets 952

1. Market information, competitive advantage and

improper trading practices 956

2. Marketmaking obligations and commitment to

the marketplace 963

3. Market surveillance in the over-the-counter

markets 968

XXXIV

CHAPTER VIII— Continued

Page

D. Conclusions.. 972

1. Real-time last sale reporting and representative

bid and ask quotations 972

2. An over-the-counter market for options traded

on exchanges 976

3. The integration of trading of options and their

underlying securities in the over-the-counter

markets 980

VI. The New York Stock Exchange and standardized options

trading 983

A. The predominant position of the New York Stock Ex-

change in the markets for underlying securities 987

1. NYSE market share 987

2. NYSE financial resources 988

3. NYSE marketmaking resources 990

4. Additional NYSE resources 991

B. Potential NYSE predominance of the standaidized op-

tions markets. 994

1. NYSE and the primary market designation 994

2. NYSE facilities advantage 995

3. NYSE advantage with respect to combined

orders 99(3

4. NYSE financial resources 997

5. NYSE marketmaking resources and advantages- 999

6. NYSE ability to attract talent 1005

C. Conclusions 1007

1. The predominant position of the New York

Stock Exchange 1007

2. The New York Stock Exchange and the statutory

dilemma 1014

3. A cautious approach 1021

VII. A national market system for standardized options 1028

A. Options and the evolving national market system 1028

B. Options and the objectives of a national market system- 1030

C. The form of a national market system 1035

1. A comprehensive quotation system 103(>

2. Market linkage and order routing systems 1044

3. Nationwide limit order protection 104B

4. Off-board trading restrictions 1049

Table 1 — Call option classes which have been listed on two or more options

exchanges 1051

Table 2 — Summary of price continuity data for call options multiply

traded on CBOE and AMEX 1052

Table 3 — Summary bid/ask spread data for call options multiply traded

on the CBOE and AMEX 1053

Table 4 — Total contract volume for call options listed on both AMEX

and CBOE 1054

Table 5 — Summary price continuity data for call options multiply traded

on both a primary and secondary exchange 1055

Table 6 — Summary bid/ask spread data for call options multiply traded

on both a primary and Secondary exchange 1056

Table 7 A — Weekly average variation in price per transaction for DuPont
Corp. call options on AMEX for the three months prior to and following
initiation of multiple trading 1057

Table 7B- — Weekly average variation in price per transaction for DuPont
Corp. call options on CBOE for the three months following initiation
of multiple trading 1058

Table 8A — Weekly average bid/ask spread for DuPont Corp. call options
on AMEX for the three months proir to and following initiation of
multiple trading 1059

Table 8B — Weekly average bid/ask spread for DuPont Corp. call options

on CBOE for the three months following initiation of multiple trading. 10(>0

Table 9 A— Weekly average variation in price per transaction for Merrill
Lynch call options on AMEX for the three months prior to and fol-
lowing initiation of multiple trading 1061

XXXV

Table 9B — Weekly average variation in price per transaction for Merrill

Lynch call options on CBOE for the three months following initiation pa£e
of multiple trading 10G2

Table 10A — Weekly average bid/ask spread for Merrill Lynch call options
on AMEX for the 3 months prior to the following initiation of multiple
trading 1003

Table 10B — Weekly average bid/ask spread for Merrill Lynch call options

on CBOE for the 3 months following initiation of multiple trading,- _ 1064

Table 11A — Summary price continuity and bid ask spread information

organized by size of option premium for Dupont Corporation 1065

Table 11B — Summary price continuity and bid/ask spread information

organized by size of option premium from Burroughs Corporation 10*57

Table 11C — Summary pi ice continuity and bid/ask spread information
organized by size of option premium for Digital Equipment Corpora-
tion I 1069

Table 12 — Exchange market share in options listed on both a primary and
secondarv exchange for selected days from February 24, 1977 through
August 31, 1977 _* 1071

Table 13 — Exchange market share in options listed on CBOE and AMEX

for selected days from February 24, 1977 through August 31, 1977—- 1072

Table 14 — Exchange market share in options which were multiply traded

foi selected days from February 24, 1977 through August 31, 1977 1073

Table 15 — Contract volume and market share of the CBOE and AMEX

for August 1978 1074

Table 16 — CBOE monthly contract volume and market share for American
Express, Ballv Mfg., Digital Equipment and National Semiconductor
from 1/1/78 to 10/31/78 1075

Table 17 A — CBOE market share in national semiconductor 1076

Table 17B — CBOE market share in digital equipment 1077

Table 17C— CBOE market share in Bally 1078

Table 17D— CBOE market share in American Express 1079

Table 18 — Comparison of Ballv Mfg. opening prices on AMEX and CBOE,

September 1, 1978 1 1080

Table 19 — Total options revenue for secondary exchanges and percentage

of total exchange revenues 1081

Table 20 — Total options net income for secondary exchanges and pei-

centage of total exchange net income 1081

Table 21 — Total revenues derived from option transaction charges on

secondarv exchanges and percentage of total options revenues 1081

Table 22— CBOE Table A: NYSE market share 1082

Table 23 — CBOE Table B: Distribution of market in certain common

stock? selected and eligible foi exchange option trading 1083

Table 24 — CBOE Table C: comparative financial information for self-
regulatory organizations (thousands of dollars) 1084

Appendix Exhibits * :

1. Letter to George A. Fitzsimmons, Securities and Exchange Com-

mission from James E. Buck, secretary, New York Stock Ex-
change dated September 22, 1978; and Letter to George A.
Fitzsimmons, Secretary, Securities and Exchange Commission,
from James E. Buck, secretary, New York Stock Exchange,
dated November 29, 1978.

2. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Joseph W. Sullivan, president,
Chicago Board Options Exchange, dated September 22, 1978.

3. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Elkins Wetherill, president, Phila-
delphia Stock Exchange, dated September 25, 1978.

4. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Charles J. Henry, president, Pacific
Stock Exchange, dated September 22, 1978.

5. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Robert J. Birnbaum, president,
American Stock P^xchange, dated September 29, 1978.

* These Appendix Exhibits are publicly available in the Commission's Public Reference Room and.
therefore ar^ not published as a part of this report.

XXXVI

Appendix Exhibits: Continued

Letter to George A. Fitzsimmons, Secretary, Securities and Ex-
change Commission, from Gordon S. Macklin, president,
National Association of Securities Dealers, dated September 22,
1978.

Letter to Richard I. Weingarten, special counsel, Special Study
of the Options Markets, from Joseph W. Sullivan, president,
Chicago Board Options Exchange, dated October 11, 1978.

Pacific Stock Exchange Study comparing Pacific Stock Exchange
and Chicago Board Options Exchange markets in Houston Oil
and Minerals Corporation and Teledyne Corporation during
December, 1976.

CHAPTER I
INTRODUCTION

Listed options are complex securities. To those wno understand
now tney worK, they may otter an alternative to snort term stocK trading
at lower commission costs ana a smaller commitment of capital. They
also provide a means tor smiting the risK ot unfavorable short term
stocK price movements from owners ot stocK who have, but do not wish
to Dear, those risxs/ to otners who are willing to assume such risks
in anticipation ot possible rewards from favorable price movements.

aut, ootn tne purcnasing and writing (selling) of options involve
a nign degree ot financial risK. Only investors wno understand those
nsKS, and wno are able to sustain the costs and financial losses
tnat may oe associated with options trading should participate in
tne listed options marxets. Too often, puoiic investors have been
encouraged to use listed options without regard to the suitability
ot options tor their investment needs.

n. Tne Orowtn ot Listed Cptions Trading

Tne volume of trading in listed options has grown substantially since
Leoruary, 1973 when tne Camiission authorized the Chicago Board Options
Lxcnange ("CtsOL") to inaugurate sucn trading as a pilot program. 1/

1/ securities Lxcnange Act Release No. 9985 (February 1, 1973).

(1)

The CBOE's Dilot program, designed to "test the market" for listed
ootions, was initially limited to call options on only 16 underlying
stocks. As listed options gained in popularity, the options markets
exoanded sharplv over the next four years:

— The number of exchanges trading options
qrew from one, in 1973, to five in 1977
(see Figure 1) .

— By mid-1977 the number of stocks on which
call options were traded had increased
from 16 to 219, and put options had been
added for 25 of those stocks causing a
surqe in open interest and volume (see
Figure 2) .

— The volume of listed options trades, measured
by the number of shares receivable on exercise
of an options contract, expanded from the
equivalent of 2.6 percent to the NYSE's total
share volume in 1973 to almost 75 percent

of that volume during the first six months
of 1978 (see Fiqure 3).

— Premiums paid for options contracts increased
in the agqregate from .3 percent of the dollar
value of shares traded on the New York Stock
Exchange ("NYSE") in 1973 to 8.2 percent
durinq the first six months of 1978 (see
Fiqure 4) .

The addition of new optionable stocks to those already traded was one
element in the rapid expansion of listed options volume. However,
an examination of volume trends for CBOE listed calls (excluding those
also traded on other exchanges) based on when each class was intro-
duced, as shown in Figure 5, indicates that the opportunity to rapidly ex-
oand volume by adding new listings, while extremely important in the early

Figure 1
THE EXCHANGES ON WHICH LISTED OPTIONS ARE OFFERED

Trading in listed calls began on the:

April 1973
January 1975
June 1975
April 1976
Deceirber 1976

Chicago Board Options Exchange
American Stock Exchange
Philadelphia Stock Exchange
Pacific Stock Exchange
Midwest Stock Exchange

June 1977

Trading in listed puts began on all exchanges
which traded listed calls.

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years of ODtions exchange development, has now substantially diminished

for call options. The options exchanges themselves had an incentive to

list those issues which they thought would have consistently high trading

activity. The statistics show that even if no additional classes had

been listed after 1973, trading volume on the CBOE by the end of 1977

would have expanded about eight fold over 1973's total as compared to

the 16 fold growth recorded when the trading volume for the classes

listed after 1973 is included. When the volume in multiply listed call

options and puts is also included, 1977 trading volume is shown to be

22 times qr eater than volume in 1973. The criteria established by the

ootions exchanges, and approved by the Commission, for stock selection

were designed to assure that options were written only on issues of

large, well capitalized firms with a large number of shares outstanding

and substantial volume of activity. The remaining pool of eligible underlying

stocks on which call options classes could profitably be introduced under

the listing standards of the options exchanges appears to be increasingly

limited .

The addition of puts to all underlying stocks on which calls are
currently traded could be expected to increase total options volume
significantly, fere again, however, the historical record does not
suggest that volume growth from this puts trading should be as dramatic
as the volume growth was in the call market, in particular, because

"synthetic" puts are now being created to substitute for listed put options. _2/
Moreover, out options were never as popular as call options in the over-the-
counter ("OTC") options market, rarely capturing 40 percent of the total
ootions volume of OTC ootions and more often accounting for between one-fourth
and one-third of such volume.

B. Effect of Listed Options Trading on the Securities Industry

The growth of listed options trading has resulted in a substantial
increase in options-related commission revenues earned by broker-dealer
firms. Stanford Research Institute has estimated that commissions on
listed ootions received by New York Stock Exchange ("NYSE") members more
than tripled from 1973 to 1974, increasing from $12 million to $45 million. 3/
In 1975, when registered broker-dealer firms first reported their options
commission revenue separately from other commission revenues in their
reports to the Commission, 853 registered broker-dealers reported receiving
$257 million in options commissions. By 1976, listed options commissions
received by broker-dealers had increased to $367 million, accounting for
about ten percent of total commission revenues related to the securities

2/ See infra, Chapter III.

_3/ SRI International, Chapter Ten, "Options," excerpted from,
Outlook for the U.S. Securities Industry - 1981, p. 13.

business. The first year-to-year decline in options commission revenues
occurred in 1977 when those revenues fell by about 13 percent to $319
million.

The importance of listed options commissions to broker -dealers has
varied qreatly among firms as shown in Figure 6. For example, of the
1039 firms reporting options commission income in 1977 , fourteen firms
received over fifty percent of the industry's total listed options commis-
sions and 78 percent of total listed options commissions were received
bv 51 firms. On the other hand, over 75 percent of the members of
the brokerage community received less than $100,000 in listed options
commissions and 40 percent of the 1039 firms received less than $10,000
from this source.

Besides earning direct commission revenues from options trans-
actions, broker-dealer firms also earned significant revenues from
"oDt ions-related" agency transactions. These transactions occur
when a customer acouires or sells stock in connection with an options
strategy, as, for example, when a customer sells stock short to write
a covered out. Firms do not separately report the amount of options-
related aqency business they do, and, accordingly, the amount of
revenues they earn is not known .

In addition to the agency business done by broker -dealers, a sub-
stantial number of firms and individuals engage in marketmaking activities

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on the floors of the options exchanges. In 1977, 1153 dealers engaged
in such activities. As is the case concerning broker-dealer firms
doinq an aqency business, the financial benefits of options marketmaking
activities have not been evenly enjoyed among marketmaking firms.
Amonq the 1153 specialist/marketmakers, 122 reported profits of
$100,00 or more from options trading in 1977, receiving over two-thirds
of the aaqregate $54 million in gross marketmaking profits reported
bv the marketmakers whose activities were profitable. Ch the other
hand, aaqregate losses of $15.9 million were reported by 413 specialist/
marketmakers and, as shown in Figure 7, 89 percent of all specialist/
marketmakers either reported losses or showed profits of less than
$100,000. Chly 12 specialist /mar ketmaker firms reported profits of
$500,000 or more.

C. Studies of Economic Effects of Listed Options Trading

The most comprehensive review of the effect of options trading on
the underlying stock is the Robert R. Nathan Associates Inc. study concerning
the first nine months of trading on the CBOE. This study was updated by
the CBOE in July 1975 and again in February 1976. 4/ The study concluded
that options trading had little discernible effect on:

_4/ Review of Initial Trading Experience at the Chicago Board Options
Exchange, prepared for Chicago Board Options Exchange by Robert R.
Nathan Associates Inc., Washington, D. C, December 1974;

(footnote continued on next page)

FIGURE 7

BROKER-DEALERS REPORTING GAINS ( LOSSES ) FROM ;4ARKET
MAKING IN OPTIONS ON A NATIONAL SECURITIES EXCHANGE: 1977

($ In Thousands)

Firms With Losses

Firms With Gains of:

Number

413

Less than $10,000

188

10,000 - $24,999

150

25,000 - $49,999

157

50,000 - $99,999

123

100,000 - $249,999

250,000 - $499,999

500,000 - $999,999

,000,000 - and over

Total

1,153

Gains, (Losses)
($15,935)

733
2,502
5,801
8,547
13,268
9,280
5,706
8,176

38,078

40-940 O - 79 - 4

1) The liouidity or operational efficiency of the stock market;

2) Volume of tradinq relative to NYSE volume; or

3) Price chanqes or or ice performance relative to the NYSE
market as a whole.

The Nathan studv also concluded that:

1) Exercise of options during expiration week had no systematic
effect on the daily price behavior of the underlying stock;

2) No regular or consistent pattern could be found between the
daily open interest for expiring options exercisable below
or at the current stock price (in-the-money or at-the-
money options) and the price movements of the underlying
stocks ;

3) The average closing bid/ask spreads of options stocks was
somewhat narrower than the spreads of a sample of other
stoc ks ; and

4) The volatility of the price of the sixteen underlying stocks
on which options trading first started was less after options
trading beqan.

More recent studies, however, have concluded that there are important

interactions between options prices and stock prices around expiration

dates. The price effects observed are generally smaller in size than

(footnote continued)

Analysis of Volume and Price Patterns in Stocks Underlying
CBOE Options from December 30 , 1974 to April 30, 1975, Chicago
Board Options Exchange, July 1975; Analysis of Volume and Price
Patterns in Stocks Underlying CBOE Options from December 31, 1975
to January 16, 1976, Chicago Board Options Exchange, February 1976.

the transaction costs paid by the public, _5/ possibly because of the
effects of orofessional arbitrage. In addition, CBOE volatility data for
1977 and a recent independent study of volatility _6/ indicate, that
the decline in the volatility of CBOE stocks relative to the market
in 1974 was due to cyclical market movements, not options trading.
In 1977, the relative volatility in the market for stocks underlying
CBOF options was not much different from what it was at the beginning
of the 1970's.

Other analyses have attempted to determine the economic signifi-
cance of listed options trading on the raising of capital by business.

Fbr examole, a study was sponsored by the CBOE to assess the impact
of listed ootions on the market for new issues of common stocks
of sroll comDanies. That CBOE study developed statistics on the
overlaDoina involvement of investors in options and new issues of

5/ See Kooprasch, Robert W. , "The Impact of CBOE Option Exercises
Upon The Prices of the Underlying Common Shares," Ph. D. thesis,
Rensselaer Polytechnic Institute, Troy, New York, April 1977,
and Klemkosky, Robert C. , "The Impact of Option Expirations on
Stock Prices," Journal of Finanical and Quantitative Analysis,
September, 1978, pp. 514-517. Kopprasch points out that analysis
of the effect of expiration activity on stock prices is severely
handicapped by the absence of published uncovered position data.

_6/ Naidu, G.N. "The Effect of Option Trading on Variability of
Common Stock Returns," Presented at the Annual Meeting of the
Southern Finance Association, 1977. Naidu finds evidence of
increased relative volatility of CBOE stocks in the post-
CBOE period.

yfft

Studies of the econcmic efficiency of options trading have been
undertaken which conclude that listed options trading has resulted in
increased transaction efficiency of the options market. These
studies are based upon the fact that a put can be converted into a call
and vice versa and on the presumption that a parity should exist
between out and call premiums if the market is efficient. Systematic
deviations from parity of put and call prices provide opportunities
for professionals to take hedged positions which are profitable
and indicate market inefficiencies.

Fbllowing uo earlier work by Gould and Galai in CTC
ootions 10/ Klemkosky and Resnick examined data on the secu-
rities for which both puts and calls were available in the listed
market. 11/ Gould and Galai found persistent large variations in
relative out-call prices in conventional options. Klemkosky and

10/ Relying on the principle of put and call parity, Gould and Galai
analyzed 159 pairs of closely matched options from the trans-
actions recorded by an options broker. They found that the parity
model is frequently violated in that there were many instances
in which riskless conversion activities could have been profitably
undertaken. Divergences from theoretical expected values were
larae, even larger than transactions costs. Gould, J. P. and
Galai, D. , "Transactions Costs and the Relationship Between Put
and Call Prices," Journal of Financial Economics, July 1974,
po. 106, 117, 112.

11/ Klemkosky, Robert C. and Resnick, Bruce G., "Put-Call Parity

and Market Efficiency" presented to Southern Finance Association
Annual Conference, NDvember 1978, Washington, D. C. , pp. 21-22.

small companies and other comparative information on the opinions,
attitudes and activities of investors. Among the conclusions of the
OBOE study are the following:

1) The frequently expressed belief that exchange
trading of options has caused a negative impact
on the market for small new issues is based on
conjecture, mostly of an uninformed nature.

2) There was no significant evidence that exchange
trading of options has had a negative effect

on the market for small new issues. 7/

In the CBOE study, 40 percent of options buyers who invested in both
options and new issues claimed that the availability of listed options
was one of the reasons for reduced purchases of new issues. These investors
also indicated that if listed options were not available, the percentage
of their portfolio typically going to small, new equity issues would
rise from 1.3 percent to 1.7 percent. 8/ This CBOE study concentrated
on the impact of options trading as opposed to the ultimate effects
of options transactions. Tnere has been no study of the secondary
effects on the flow of funds between the options market and other
investments. 9/

!_/ Robbins, Sydney V ^ugh, Robert E., Sterling, Francis L.

and HDwe, Tnomas \ Impact of Exchange-Traded Options

on the Market for Iv ues of Common Stock of Small Companies,

Management Analysis C r, Cambridge, Massachusetts, June 1977,
pr>. 3-4.

_8/ Robbins, et al , p. A-12.

9/ As noted earlier, commissions on options transactions amounted
to about $367 million in 1976 and $319 million in 1977.

Resnick found a lower incidence of such divergences in the listed
out-call market.

D. Summary and Conclusions of the Options Study

The rapid qrowth in options volume and the appearance of abuses

resulted in the Commission initiating an investigation and study of

the standardized listed options markets on October 17, 1977. The

Commission stated its concern about:

(1) the present ability of the self -regulatory
organizations' surveillance systems to detect
and prevent fraudulent, deceptive, and manipulative
activity, both in options and in underlying secu-
rities, in a manner which is consistent with the
maintenance of fair and orderly markets and the
protection of investors and that complies with
the reauirements of the [Securities Exchange]
Act; (2) the adequacy of existing Commission and
self-requlatory organization rules to prevent
fraudulent, deceptive and manipulative acts,
practices, devices and contrivances in connection
with options trading; (3) the development of the
standardized options markets in a manner which is
consistent with the public interest in perfection
of the mechanisms of a national market system for
securities and prevention of securities trading
which adversely affects the financing of trade,
industry and transportation in interstate commerce;
and (4) the development of appropriate standards,
formulated with reference to the purposes of the
Act, by which to measure the appropriateness of
particular programs which would have the effect
of expanding or altering existing pilot options
trading programs. 12/

12/ Securities Exchange Act Release No. 14056 (October 17, 1977)
("October Release") pp. 3-4.

As a direct result of these concerns, the Special Study of the
Options Markets ("Options Study") was established to determine
whether standardized ootions tradinq is occurring in a manner . and in
an environment which is consistent with fair and orderly markets, the
public interest, the protection of investors, and other objectives
of the [Securities Exchange] Act, and to ascertain what, if any,
additional action is necessary and proper to aid in the enforcement
of the provisions of the Act and the rules thereunder to protect
investors and to insure fair dealing in the trading of standardized
options and their underlying securities.

The Options Study has addressed many of the concerns expressed
by the Commission in the October Release. The findings and conclusions
of the Options Study will be discussed in detail in the various chapters
to this report. The Ootions Study's principal conclusions and the
steDS that the Options Study recommends the brokerage community, the
self-regulatory orqanizations, and the Commission should take to improve
the regulatory framework for the listed options markets to assure
that these markets are fair and orderly are summarized below.

1. Self-Regulatory Organization Systems

a. Market Surveillance
Market surveillance is the process of detecting trading practices
that may be inconsistent with Securities Exchange Act of 1934 ("Exchange

Act"), the rules and regulations thereunder, and the rules of self-
requlatory orqanizations. Self -regulatory organizations engage in
surveillance activities because, among other reasons, the Exchange
Act assiqns them responsibility, subject to Commission oversight,
for assuring that their markets are fair, honest, and orderly
and that their members comply with the federal securities laws.

An effective market surveillance system must be able to produce
essential trading information quickly and accurately. It must be able
to identify the brokers participating in each trade, the firms clearing
the trade, the time that the trade occurred, the price to which the
parties have aqreed, the number of shares or contracts bought and sold,
and whether the trade was executed for a customer, firm, or marketmaker
account. Ultimately, the system must be able to identify, where
appropriate, the customer that effected a transaction. In addition,
the system must be able to identify bids, offers, and orders that
were present in the trading crowd to obtain a complete picture
of the trading environment at a particular time. lb the extent
that this information is readily available, the ease of performing
surveillance functions and designing surveillance programs is increased.

A surveillance system must also provide its user with a physical
record of the trading and other market activity that the system monitors.
Such a record, often referred to as an audit trail, is necessary to verify
the information that the system produces. In particular, documentary evidence

must be maintained either in or by the system if potentially improper
trading practices are to be successfully investigated and resolved.

The Options Study reviewed the techniques that the self-regulatory
orqanizations have developed to detect manipulative conduct involving
related stock and options trading, manipulative conduct that may be
effected using only options, misuse of nonpublic information in
connection with' options trading, and violations of the position and
exercise limit and restricted option rules. This review included
inspections of the options exchanges and the NYSE and an examination
of their investigative and enforcement files. The Options Study
found that while the best of the techniques that have been developed
would provide a self-requlatory organization with a general ability
to detect such trading practices, improvements must be made to
maximize the effectiveness of self-regulatory organization market
surveillance.

1) American Stock Exchange Surveillance
Information and Audit Trail

Each of the exchanges that permits the trading of standardized

options has some ability to identify the parties, reporting time, and terms

of trades that take place on their trading floor. In addition, each

of these exchanges has seme ability to obtain a physical record of those

trades. The extent of these abilities, however, varies significantly.

The CBOE, Pacific Stock Exchange ("PSE"), Midwest Stock Exchange
("MSE"), and Philadelphia Stock Exchange ("PHLX") can identify the buying
and selling brokers, the firms that will clear the trade, the time that
the transaction was entered into the price reporting system, the price,
the number of contracts for each trade, and whether the trade was reported
as executed for a customer, firm or market maker account. This informa-
tion is available on an automated basis the day after the trades
occur. It is customarily obtained from order tickets or transaction
reporting slips that these exchanges collect when trades are executed
and is key ounched into exchange computers from the trading floor.
The order and transaction reporting tickets are kept in case they
are needed for surveillance purposes at some later date.

The American Stock Exchange ("AMEX") , on the other hand, does not
maintain as complete a record of each options trade that occurs on its
floor. As a result, it cannot verify trade information by using its
own records. Moreover, the AMEX cannot identify, on a regular,
automated basis, the brokers that execute each options trade or the
firms that will clear the trade. Consequently, the AMEX must resort
to the slow and costly process of manually reconstructing trading
from specialist and registered option trader ("ROT") reports and from
order tickets obtained from member firms to detect and investigate
Questionable trading practices that may take place on its floor.
The need to use manual processes to reconstruct options trading

makes this reconstruction at best costly and time consuming, and at
worst impossible, for the AMEX to perform many of the surveillance
procedures that other options exchanges perform routinely.

The AMEX has recoqnized that its surveillance system does not
routinely provide information that is essential to an effective
detection program. It has also recognized that a computer could
oerform more efficiently and more completely many of the functions
that the exchange now performs manually. As a result, the AMEX has
undertaken to improve the surveillance information that the exchange
reaularlv obtains. Specifically, the AMEX intends to establish
svstems that would allow the exchange to identify the parties, terms,
and reoortinq time for each trade, and would provide a physical
record, or "audit trail," of the trade for investigation and verifica-
tion purposes. The exchange has represented that it will seek to
implement this system during the first quarter of 1979, and began a
"pilot test" of this new system on October 2, 1978.

Accordinqly, the Options Study recommends:

THE AMEX SHOULD ESTABLISH A COMPLETE AUDIT TRAIL
FOR EACH OPTIONS TRANSACTION THAT TAKES PLACE ON
THE AMEX FLOOR IN ACCORDANCE WITH THE SCHEDULE
THAT THE EXCHANGE PRESENTED. THE COMMISSION
SHOULD REQUIRE THAT THE AMEX SUBMIT A COMPLETE
REPORT ON THE RESULTS OF ITS "PILOT TEST" AS
SOON AS THEY ARE AVAILABLE. THE DIVISION OF
MARKET REGULATION SHOULD FOLLOW THE PROGRESS
OF THE AMEX CLOSELY TO ASSURE THAT THE EXCHANGE
ENHANCES THE CAPABILITIES OF ITS SURVEILLANCE
SYSTEMS AND ESTABLISHES A PROPER AUDIT TRAIL
AS QUICKLY AS POSSIBLE.

2) New York Stock Exchange Surveillance Information
and Audit Trail

The NYSE does not have the ability to identify, on a routine,

automated basis, the participants in each stock trade on its floor.

Nor does the NYSE maintain a record, collected at the time that orders
are executed, which indicates the parties, the reporting time, and
the terms of each NYSE stock trade. While the Options Study has
not examined or analyzed the NYSE stock surveillance system as
a whole, the lack of such essential surveillance information raises
a substantial concern reqarding whether the exchange has the ability
to fulfill its statutory responsibilities on a daily basis for each
stock that is traded on the NYSE floor, including those on which options
are traded. Moreover, despite the NYSE's recent initiation of a multi-
million dollar "trading facilities upgrade project," the exchange
has not yet committed itself to obtain regularly the surveillance
information that it lacks. 13/

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INSPECTION
OF THE NYSE MARKET SURVEILLANCE SYSTEM TO DETERMINE
WHETHER THE EXCHANGE HAS THE ABILITY TO CARRY OUT
THE PURPOSES OF THE ACT AND TO COMPLY, AND ENFORCE
COMPLIANCE BY ITS MEMBERS, WITH THE ACT, THE RULES
AND REGULATIONS THEREUNDER, AND NYSE RULES.

13/ Letter to Harold M. Williams, Chairman, Securities and Exchange
Commission, from William M. Batten, Chairman, New York Stock
Exchange, dated October 16, 1978.

SPECIFICALLY, THE INSPECTION SHOULD CONSIDER
WHETHER THE NYSE CAN DETECT, ON A DAILY BASIS AND
FOR EACH STOCK TRADED ON THE NYSE, TRADING
PRACTICES THAT MAY BE INCONSISTENT WITH THE
ACT, THE RULES AND REGULATIONS THEREUNDER, OR
EXCHANGE RULES. THE INSPECTION SHOULD BE
CONDUCTED AND COMPLETED AS EXPEDITIOUSLY AS
POSSIBLE AND A COMPLETE REPORT SHOULD BE
PRESENTED TO THE COMMISSION WITHIN SIXTY DAYS
AFTER THE COMPLETION OF THE REVIEW.

IN THE EVENT THAT THE INSPECTION REVEALS THAT
THE NYSE CANNOT FULFILL ITS STATUTORY RESPONSI-
BILITIES ON A DAILY BASIS, THE COMMISSION SHOULD
TAKE APPROPRIATE REMEDIAL ACTION AND SHOULD
SPECIFICALLY CONSIDER REQUIRING, BY COMMISSION
RULE, THAT THE EXCHANGE COLLECT AND MAINTAIN
ESSENTIAL SURVEILLANCE INFORMATION WITH REGARD
TO EACH NYSE TRADE.

3) Firm Proprietary and Customer Trading Information
Certain surveillance information that is essential to effective
market surveillance is not readily available to any self-regulatory
orqanization. Specifically, the stock clearing process does not
distinguish between firm proprietary and customer stock positions,
and the identity of customers who effect stock or options trades cannot
be determined using surveillance information that is easily accessible
to the self-regulatory organizations. Self-regulatory organizations
must seek this information from the firms that entered the orders on
behalf of the customers. As a result, investigations into firm
proprietary stock trading, and into customer trading generally,

require frequent, costly and time-consuming correspondence oetween
self -regulatory organizations and their member firms for the purpose
of identifying the accounts involved in trading activity.

The NYSE and the Securities Industry Automation Corporation ("SIAC"),
however, have initiated studies to determine the cost and feasibility
of distinguishing between firm proprietary and customer trading, and of
ootaining customer account identification information in the stock
clearing process. Tney have represented that these studies will be
completed oy March 31, 1979. 14/

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD REVIEW THE SIAC REPORT
CONCERNING FIRM PROPRIETARY AND CUSTOMER TRAD-
ING AS SOON AS IT IS COMPLETED. THE SELF-
REGULATORY ORGANIZATIONS AND THEIR MEMBER FIRMS
SHOULD WORK TO ESTABLISH AN ECONOMICAL METHOD
FOR IDENTIFYING AND DISTINGUISHING MEMBER E I
PROPRIETARY AND CUSTOMER STOCK ORDERS AND
TRANSACTIONS. IN THE EVENT THAT THE SELF-REGULATORY
ORGANIZATIONS DO NOT DEVISE A METHOD FOR EASILY
IDENTIFYING MEMBER FIRM PROPRIETARY AND CUSTOMER
TRADING, THE COMMISSION SHOULD CONSIDER WHETHER
IT IS APPROPRIATE TO REQUIRE THAT THEY DO SO BY
COMMISSION RULE.

IN ADDITION, THE COMMISSION SHOULD BEGIN TO STUDY
THE MOST APPROPRIATE MEANS OF ESTABLISHING A
UNIFORM METHOD OF IDENTIFYING STOCK AND OPTION
CUSTOMERS ON A ROUTINE, AUTOMATED BASIS. THE
COMMISSION SHOULD REVIEW THE NYSE AND SIAC REPORT
ON THIS SUBJECT AND SHOULD DETERMINE THE STEPS
THAT SHOULD BE TAKEN TO ESTABLISH A UNIFORM
ACCOUNT IDENTIFICATION SYSTEM IN LIGHT OF THE REPORT.

4) Options Clearing Corporation Position Adjustments
The Options Study has found that surveillance information currently
available from the Options Clearing Corporation ("CCC") may be inadequate
to detect abuses in the position adjustment process. Position adjustments
mav be used to accomplish improper purposes such as trade reversals,
ooeninq transactions by customers or firms in restricted options, and
the avoidance of public priority rules for limit orders and off-floor
tradinq. But clearing firms may submit position adjustments to the

14/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from Robert M. Bishop, Senior Vice-President, New York
Stock Exchange, dated September 28, 1978

OCC for several legitimate reasons: To correct errors and omissions

that mav occur when the teens and parties to an options trade are

entered into the computers of the firms for clearing purposes; to

transfer accounts between two clearing firms; or to adjust records

when one clearing firm executes and compares trades for another firm

on an options exchange of which the second firm is not a member.

the OCC has* undertaken to improve the surveillance information

that is available with respect to position adjustments. By the end

of the first auarter of 1979, the OCC will separately identify and

distinguish all oosition adjustments involving transfers of accounts
and adjustments that occur because a firm is not a member of the exchange

on which a transaction that the firm cleared was effected. The OCC

will also prohibit adjustments between clearing firms and will code

and identify certain types of adjustments. Tne Options Study believes

that these changes will substantially reduce the potential for abusing

the adjustment Drocess and will improve the ability of the self-

reaulatory organizations to monitor adjustments.

Accordingly, the Ootions Study recommends:

THE OCC SHOULD IMPLEMENT ITS PROPOSED REVISIONS
IN THE POSITION ADJUSTMENT PROCESS AS SCHEDULED.
THE OCC SHOULD ALSO STUDY THE FEASIBILITY OF FURTHER
REDUCING THE NUMBER OF POSITION ADJUSTMENTS BY
REQUIRING ITS MEMBERS TO RECONCILE THEIR ACCOUNTS
TO OCC RECORDS ON A DAILY BASIS AND BY IMPOSING
A SURCHARGE ON FIRMS THAT SUBMIT AN EXCESSIVE
NUMBER OF ADJUSTMENTS. THE RESULTS OF SUCH A
STUDY SHOULD BE SUBMITTED TO THE DIVISION OF
MARKET REGULATION WITHIN NINETY DAYS.

5) The Sharing of Surveillance Information

and the Allocation of Regulatory Responsibility

The Ootions Study observed a need for greater coordination of

self-reaulatory surveillance Drograms and for the sharing of

surveillance information. The Options Study has discussed these

matters with the self-regulatory organizations with a view toward

establishing a "more coherent and rational regulatory structure"

for market surveillance. 15/ During August and September 1978,

15/ S. Reo. No. 94-75, 94th Cong., 1st Sess. 2 (1975).

reoresentatives of the options exchanges, the NYSE, the National

Association of Securities Dealers ("NASD"), the OCC, and the Boston

Stock Exchange (collectively the "Self-Regulatory Conference" or

the "Conference") met to discuss the —

need for the creation of an integrated
requlatory system among the [self -regulatory
organizations] which would enhance total
industry regulatory capability by coordinating
and interfacing existing regulatory data and
programs through the sharing of available
information, improvement of regulatory
techniaues, [and] the allocation of regula-
tory responsibility. . . . 16/

The members of the Conference "acknowledge that the establishment of

a more fully integrated regulatory system is both necessary and desirable

as a means of establishinq more efficient and effective regulation

which mav be cost-effective to the industry and achieve minimum standards

of regulation on an industry wide basis thus assuring the protection of

oublic investors." 17/

Durinq their working sessions, the members of the Self-Regulatory

Conference identified all market surveillance reports and information

oresently available and reached a "consensus that the sharing of data

16/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self -Regulatory Conference, dated October 6,
1978, at p. 2.

17/ Id., at p. 3.

... is both needed and desired." 18/ They specified the surveillance
information that they would like to receive from each other on a routine,
automated basis and agreed generally to share all surveillance informa-
tion. In addition, they agreed to consider principles for allocating
surveillance responsibilities among themselves and agreed to continue
their meetinas to implement their information sharing plans and "to
allocate additional responsibilities with respect to matters arising
from inter-market regulatory problems and to further eliminate regulatory
duplication." 19/ They also invited the Commission to send a representative
to future meetings. The Options Study believes that implementation
of the initiatives that the Conference has taken is necessary to assure
that self-requlatory surveillance programs are maximally effective.
Accordinqly, the Options Study recommends:

THE COMMISSION SHOULD CLOSELY MONITOR THE EFFORTS
OF THE SELF-REGULATORY ORGANIZATIONS TO SHARE
SURVEILLANCE INFORMATION AND COORDINATE SELF-
REGULATORY ACTIVITIES. THE COMMISSION SHOULD
ACKNOWLEDGE BY LETTER THE FORMATION OF THE
CONFERENCE AND SUGGEST THAT THE USE OF SECTION
17(d)(2) OF THE ACT AND RULE 17d-2 THEREUNDER
TO ALLOCATE SURVEILLANCE RESPONSIBILITIES AMONG
THE SELF-REGULATORY ORGANIZATIONS IS APPROPRIATE
AND DESIRABLE. IN ADDITION, THE COMMISSION SHOULD
SEND A REPRESENTATIVE TO FUTURE MEETINGS OF THE
CONFERENCE. THE COMMISSION SHOULD ALSO SEEK TO
COORDINATE ITS OWN SURVEILLANCE OPERATIONS WITH
THOSE OF THE SELF -REGULATORY ORGANIZATIONS.

18/ Id., at p. 4.
19/ Id., at p. 12.

40-940 O - 79 - 5

6 ) Investigation and Enforcement

The detection of trading that may be inconsistent with the federal
securities laws cannot, however, be the end of surveillance. When
such trading is detected, it must be investigated to determine whether
the Exchange Act or self-regulatory organization rules have been violated,
Moreover, where violative conduct is found, the federal securities laws
and self-regulatory organization rules must be enforced and the conduct
sanctioned with a view toward punishing the violator and deterring
future violations. The Options Study's inspections of the options
exchanges revealed significant differences in the thoroughness and
effectiveness of their investigation and enforcement programs.

Generallv, CBOE and PSE investigations were complete and adequately
documented. At the FHLX, on the other hand, the extent of investigatory
and enforcement efforts was difficult to evaluate because much of the
investigatory process was informal and undocumented.

Accordingly, the Options Study recommends:

THE PHLX SHOULD PROVIDE COMPLETE DOCUMENTATION
WITH RESPECT TO ROUTINE SURVEILLANCE FUNCTIONS AND
INVESTIGATIONS THAT THAT EXCHANGE PERFORMS. SUCH
DOCUMENTATION IS NECESSARY TO ASSURE THAT THE PHLX
IS CARRYING OUT ITS STATUTORY RESPONSIBILITIES
PROPERLY.

The Options Study's inspection of the AMEX revealed that trading
practices that may have been inconsistent with the Exchange Act or
AMEX rules were often detected and investigated. Subsequently, however,
the AMEX staff closed many cases with no action even though the
circumstances suggested that a violation may have occurred. The Options
Studv found the AMEX case closing procedures troublesome because AMEX
cases were seldom formally prepared and, perhaps as a result, factual
and legal argument and analysis were not as precise or thorough as
the Exchange Act reouires. In addition, the AMEX staff often closed
cases because it was of the view that a panel of AMEX members would
not impose disciplinary sanctions under the circumstances of the case.
As a result, the AMEX staff is effectively able to set the legal
and ethical standards for trading conduct on the AMEX floor with
no involvement of the AMEX membership. Recently, however, the AMEX
undertook to form a special committee of its Board of Governors,
to review, among other things, all investigative and enforcement
activities of the staff.

Accordingly, the Options Study recommends:

THE AMEX SHOULD FORM A SPECIAL COMMITTEE OF

ITS BOARD OF GOVERNORS THAT WILL REVIEW THE

INVESTIGATION AND ENFORCEMENT ACTIVITIES OF

THE EXCHANGE. THE COMMITTEE SHOULD BE COMPOSED,

AS THE AMEX SUGGESTED, OF FLOOR AND NONFLOOR

MEMBERS, EXCHANGE OFFICIALS AND A REPRESENTATIVE

OF THE PUBLIC. IN ADDITION TO ITS GENERAL REVIEW,

THE COMMITTEE SHOULD SPECIFICALLY EXAMINE, AT
IEAST EVERY SIX MONTHS, EVERY INVESTIGATIVE FILE
IN WHICH THE INVESTIGATIVE AND ENFORCEMENT
ACTIVITIES OF THE STAFF HAVE BEEN COMPLETED.
THE FILE SHOULD IDENTIFY THE REASONS THAT THE
INVESTIGATION WAS INITIATED, THE STEPS THAT
WERE TAKEN TO INVESTIGATE THE MATTER, THE CON-
CLUSIONS THAT WERE REACHED CONCERNING EACH
ASPECT OF THE POTENTIALLY VIOLATIVE CONDUCT,
THE RATIONALE FOR EACH CONCLUSION, AND FULL
DOCUMENTATION TO SUPPORT THE RESULT.

FURTHER, COMMISSION INSPECTIONS OF THE AMEX
SHOULD EMPHASIZE A REVIEW OF CASE FILES
THAT ARE CLOSED AFTER INVESTIGATION TO ASSURE
THAT AMEX ENFORCEMENT RESPONSIBILITIES ARE
PROPERLY CARRIED OUT.

An inspection of the MSE options surveillance program caused the
Options Study concern in two areas. First, although MSE documents
indicated the exchange had detected numerous instances of trading
that may have been inconsistent with the Exchange Act or MSE rules,
no records were maintained indicating whether any subsequent investi-
gation was done. As a consequence, it is impossible to determine
the regularity, adequacy, or extent of investigations of potential
improprieties that the MSE surveillance system detected. Second, the
case files that the Options Study reviewed demonstrated that MSE
investigations that were conducted were often incomplete and concluded
prematurely.

Accord inqlYf the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INVESTIGATION
OF THE MSE OPTIONS SURVEILLANCE PROGRAM. THE INSPECTION
SHOULD SEEK TO DETERMINE WHETHER THE MSE HAS THE ABILITY
TO ENFORCE COMPLIANCE WITH THE ACT AND MSE RULES WITH
RESPECT TO OPTIONS TRADING ON THE MSE FLOOR.

b. Broker-Dealer Oversight

Each of the self -regulatory organizations has monitoring, investi-
gation, examination, and disciplinary programs to assure that their broker -
dealer member firms comply with the federal securities laws and the
self-regulatory organization rules governing, among other things,
sellinq practices. The Options Study reviewed the broker-dealer
sales practice programs and investigative and enforcement files
at the options exchanges and the NYSE and conducted: interviews
with officials of self -regulatory organizations regarding the
operations of these programs. The Options Study found that broker-
dealer oversight urograms of the self-regulatory organizations
have been inadequate to assure the protection of the public.

The self-regulatory organizations, in their oversight of member
firms, fail to use public customers as a source of valuable regulatory
information and to collect relevant data from one another. Public
customers are not routinely questioned in conjunction with examinations
and investiqations of member firms and their associated persons and,

tneretore, self-regulatory oryanizations frequently terminate
investigations prematurely or tail to pursue potential violations
uncovered by routine examinations, 'mere is also no routine exchange
auong sell -regulatory oryanizations of essential compliance information,
sucn as tne results of examinations, investigations and informal
disciplinary actions. Accordingly, the self -regulatory organizations
in many instances nave an inaccurate perception of tne conduct of
tneir member firms.

riucn valuable information available from member firms is not
assembled ana evaluated by selt-regulatory associations, primarily
oecause the sell-regulators have not sought access to such data.
Moreover, userul information available from government agencies is
neitner sougnt nor used routinely.

Investigations and examinations of retail sales practices by the
seit-reyulatory organizations normally concentrate only on detecting
memoer rirm taiiures to toilow record-Keeping procedures established
oy tne rules ol tne sell-regulatory organizations governing, for example,
tne opening of accounts ana approving of transactions. Self -regulatory
examination and investigative procedures are not adequately designed
or utilized to detect substantive violations, such as use of deceptive
sales loatenals, recommendations of options transactions unsuited to the
customer, and excessive or unauthorized trading in customer accounts.

In conducting an inquiry arising out of a customer's complaint
or a notification that a registered representative's employment has
been terminated because of a possible rule violation, the self-
regulatory organizations limit their inspection to the specific,
often narrow, issues raised by the complaint or termination notice.
These inspections do not consider whether other customer accounts of the
same registered representative may have experienced problems similar
to those of the complaining customer . Nor do these inspections consider
whether possibly related rule violations may have occurred which,
for one reason or other, may not have been articulated in the customer's
complaint or in the registered representative's termination notice.
Moreover, the self-requlatory organizations are generally reluctant
to resolve factual disputes between customer and firms, even though
this task normally is necessary to determine whether misconduct has
occurred.

Disciplinary action taken by the self-regulatory organizations has
been ineffective in deterring future violations. Non-public letters
of caution or other informal sanctions are too often imposed in
cases involving serious violations or injury to public investors.
The self-regulatory organizations also allow their member firms
to commit repeated rule violations without decisive remedial
action.

Tne Options btudy discussed these and other concerns with the
sell-regulatory organizations. Tne Self -Regulatory Conference agreed
mat "it snoula oe possible to establisn some industry-wide objectives
ror tne conauct or a [broxer-deaier firm] examination so as to insure
tne protection ol investors, "avoid regulatory duplication, and
eliminate regulatory voids". The Conference also agreed to consider
establisnmy programs "to pronote a sharing of relevant information
aoout broKer-dealer compliance activities and to assist in the execution
ol complete, comprenensive and thorough examinations of such firms." 20/
lowara tnis end, the Conlerence agreed "that a [central] repository
couia oe utilized to provide each self -regulatory organization with
more intormation than is presently utilized for purposes of registration
01 personnel, customer complaints, investigations and examinations." 21/
Tnis central repository would include "at least all information
regarding [registered representative] registration and termination,
customer complaints, and tormal actions taxen oy [the self -regulatory
oryamzations J and otner regulatory bodies...." 22/ The Options
btudy believes that tnese initiatives by the Self -Regulatory Conference
are constructive and that they should be implemented as soon as possible.

20/ Id. at pp. 7-b.

21/ Id. at p. 8.
22/ Icu at p. y.

The Options Study believes that additional initiatives are necessary

to remedy the deficiencies summarized above, and to establish minimum

standards for the performance of self-regulatory enforcement programs,

and therefore recommends:

SELF-REGULATORY ORGANIZATIONS SHOULD BROADEN
THE SCOPE OF THEIR EXAMINATIONS AND INVESTIGATIONS
AND ROUTINELY QUESTION PUBLIC CUSTOMERS IN ORDER
TO RESOLVE DISPUTED ISSUES OF FACT, TO DETERMINE
WHETHER THERE MAY HAVE BEEN A VIOLATION OF THE
SECURITIES LAWS OR APPLICABLE RULES, AND TO VERIFY
INFORMATION OBTAINED FROM ANOTHER SOURCE.

SELF-REGULATORY ORGANIZATIONS SHOULD DEVELOP WAYS TO
SHARE RELEVANT COMPLIANCE INFORMATION AND MORE EFFECTIVELY
ALLOCATE RESPONSIBILITY FOR BROKER-DEALER OVERSIGHT
AMONG THEMSELVES.

SELF-REGULATORY ORGANIZATIONS SHOULD RESTRICT INFORMAL
DISCIPLINARY ACTIONS TO CASES IN WHICH PUBLIC CUSTOMERS
HAVE NOT BEEN INJURED AND IN WHICH RULE VIOLATIONS ARE
MINOR OR ISOLATED.

SELF-REGULATORY ORGANIZATIONS SHOULD AMEND THEIR RULES

TO PERMIT THEM TO ORDER RESTITUTION TO INJURED INVESTORS AS

A SANCTION IN APPROPRIATE DISCIPLINARY ACTIONS.

2. Trading Practices

To determine how market professionals use options in connection
with investment and trading strategies the Options Study interviewed
more than 100 professional stock and options traders.

In addition, the Options Study examined numerous investigative
records already established by the Commission and the self -regulatory
organizations with regard to questionable trading practices such

as trace reversals, prearranged and tictitious trades, stock/option
manipulation and rront-running of blocxs. Tne purpose of tnis eftort
was co determine wnetner certain marKet professionals have access
to non-puolic marKet information and enjoy otner competitive advantages
tnat mignt oe inconsistent witn tne federal securities laws and wnetner
Commission or sell-regulatory organization action is necessary to prevent
uianipuiative or otner improper conduct in connection witn options trading.
Tne options Study, nowever, aid not conduct independent investigations
or particular trading situations. Nor was tne Options Study aole to
review and analyze trading data or investigations that the self-
reyuiatory organizations initiated in sufficient detail to form the
oasis ror regulatory recommendations. As a result, further study will
oe required to aetermine wnetner specific trading patterns can be
identitied which snould oe tne subject of proscriptive rules and to
rormulate appropriate rules where necessary.

a. Proressional Trading
Institutional investors generally write call options to limit

tne risx associated with their stock activities through the premiums
received, otner options market professionals, however, employ

a variety ol trading strategies. These options strategies seek
to realize trading profits in diverse ways: (1) speculation that
market prices wiil move either up or down, Tx stay within a given

range; (2) purchasing oDtions at the bid price and selling at the
offer txice to profit from the spread between the quotations; (3)
trading that reduces positions to a limited or neutral risk posture
to orofit from the passage of time or from price movements in the
underlvinq stock within a predetermined range; and (4) arbitrage.

The Options Study's review did not reveal that market profes-
sionals have competitive advantages that are inconsistent with the
Fxchanae Act or the public interest. Additional information must
be gathered, however, if the Commission and the self-regulatory
organizations are to understand whether the patterns, relationships,
and effects of stock and options trading by market professionals
may be inconsistent with the public interest in a manner not currently
perceived. In particular, more information is needed regarding
Datterns of trading near expiration and stock trading activities
that might be designed to benefit unfairly pre-existing options
positions.

Accordingly, the Ootions Study recommends:

THE SELF-REGUIATORY ORGANIZATIONS SHOULD USE THE
INTEGRATED SURVEILLANCE DATA BASE THAT THEY ARE
ESTABLISHING FOR STOCK AND OPTIONS TRADING TO DETECT
UNLAWFUL TRADING ACTIVITIES AND CONDUCT APPROPRIATE
ENFORCEMENT ACTIONS AND TO IDENTIFY PATTERNS OF
STOCK AND OPTIONS TRADING THAT SHOULD BE REGULATED
OR PROHIBITED. THE COMMISSION AND THE SELF-
REGULATORY ORGANIZATIONS SHOULD WORK TOGETHER TO
ESTABLISH PRIORITIES FOR THESE STUDIES AND THE
SELF-REGULATORY ORGANIZATIONS SHOULD REGULARLY
REPORT THE RESULTS OF THE STUDIES THAT THEY CONDUCT
TO THE COMMISSION.

Accord ingly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD OBTAIN AND
REVIEW ALL INSTANCES OF OPTIONS AND STOCK TRADING WHICH
ARE OR HAVE BEEN THE SUBJECT OF INFORMAL OR FORMAL
INVESTIGATIONS BY THE SELF-REGULATORY ORGANIZATIONS.
THE DIVISION OF MARKET REGULATION SHOULD REVIEW THIS
DATA WITH A VIEW TOWARD PROPOSING ANTI -MANIPULATIVE
OPTIONS AND STOCK TRADING RULES WHERE APPROPRIATE.

b. Position Limits

Existing options exchange rules prohibit a person from holding
more than 1,000 short calls and long puts with respect to any underlying
security. Position limit rules were adopted by the options exchanges
primarily to minimize manipulative potential and to prevent the accumulation
of large options positions that, if exercised, might affect the
price of the underlying stock.

The oresent position limit rules prevent certain larger investors
(primarily institutions) from writing calls or buying puts against
more than 100,000 shares of stock. As a result, the managers of certain
large portfolios do not presently use options because writing options
up to existing position limits does not provide significant risk limiting
capabilities for such large portfolios. To the extent that large
investors own the stock underlying the options they write, they need
not purchase stock to deliver on exercise of the calls they write or
the puts they buy and, therefore, may not need to effect transactions
which will substantially affect stock prices. As a result, a significant

portion of the theory underlying the position limit rules may not be
applicable to such covered investors.

Numerous market participants, including professional traders,
institutional investors, and self -regulatory organizations, have
maintained that the position limit rules should generally be liberalized
or otherwise modified. Further, the ability of some self-regulatory
orqanizations to grant their marketmakers exceptions from these
rules, and the manner and frequency with which exceptions have been
granted, has raised concern that the rules currently have an unequal
imrBct on members of different self-regulatory organizations. It
has been suggested that either the rules be made uniform for all
market oarticipants or that the self-regulatory organizations be
permitted to liberally grant exceptions, especially in instances
where a marketmaker might otherwise violate the rule when fulfilling
his obliaation to trade with public customers.

Accordingly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD UNDERTAKE A
COMPETE REVIEW OF THE POSITION LIMIT RULES OF THE
OPTIONS EXCHANGES. THIS REVIEW SHOULD INCLUDE:
(1) THE POSSIBILITY OF ELIMINATING POSITION LIMIT
RULES, (2) THE FEASIBILITY OF RELAXING POSITION
LIMIT RULES FOR (a) ALL MARKET PARTICIPANTS, (b) FOR
ACCOUNTS WHICH HOLD FULLY PAID, FREELY TRANSFERABLE
SECURITIES OR (c) FOR "HEDGED" POSITIONS, AND (3)
WHETHER EXCEPTIONS FROM THE RULES SHOULD BE GRANTED
TO OPTIONS SPECIALISTS AND, IF SO, UNDER WHAT
CIRCUMSTANCES.

c. Claritication of Trading Rules

Following the commencement ol the Options Study, the CBOE issued
euucational circulars to its members discussing coth specific trading
activities tnat nay be considered manipulative and the misuse of market
mtormation involving those options trades wnich taKe place prior to
tne puuiic aissemination ot mtormation concerning a large stock
trade. The Options Study believes that this type of educational
circular identities and nelps to prevent improper activity, particu-
larly in tne area ot front- running.

accordingly, the Options Study recommends:

ALL SELF-REGULaTORY ORGANIZATIONS SHOULD (1) ISSUE
INTERPRETATIONS OF THEIR RULES TO MAKE CLEAR THAT FRONT-
KUNNING IS INCONSISTENT WITH JUST AND EQUITABLE PRINCIPLES
OF TRADE BY ITS MEMBERS AND, (2) TAKE PROMPT DISCIPLINARY
ACTION AGAINST THOSE MEMBERS WHO HAVE BEEN FOUND TO HAVE
ENGAGED IN FRONT-RUNNING.

Tne Commission should also take steps to clarify the law when
necessary or appropriate. In tne area ot related stock and options
trading, tor example, there nas been much debate concerning tne
types ot trading that might be considered manipulative. Wnile
tne Commission nas proceeded against intermarket manipulation in
reliance upon section 10(b) ot the Exchange Act, and Rule 10b-5
tnereunder, tne applicability of Section 9(a)(2) of the Exchange
Act to sucn activities remains unsettled.

Trie uncertainty arises because Section 9(a)(2) applies to "a
series ot transactions in any security . . . creating actual or apparent
active trading in sucn security or raising or depressing the price

of such security, for the purpose of inducing the purchase or

sale of such security by others." Neither the Commission nor

the courts has resolved the auestion of the applicability of

this section to related stock and options trading. The Options

Study believes that this issue should be resolved by making it

clear that stock transactions effected to benefit options positions

fall within the scope of Section 9.

Accordingly, the Cptions Study recommends:

THE COMMISSION SHOULD ISSUE AN INTERPRETIVE RELEASE
OR INITIATE RULEMAKING PROCEEDINGS SPECIFICALLY
TO CLARIFY THAT INTER-MARKET MANIPULATIVE TRADING
ACTIVITY INVOLVING OPTIONS AND THEIR UNDERLYING
SECURITIES MAY VIOLATE SECTION 9.

Shortly after listed option trading began, the options exchanges adopted

so-called restricted options rules which were designed to prevent

unwarranted speculation in deep out-of-the-money options. Restricted

options rules tend to limit legitimate trading activities of some

options customers. The Options Study believes that improvements in

the customer suitability and its enforcement may, at a future date,

allow the elimination of the restricted options rules. Accordingly,

the Options Study recommends :

THE DIVISION OF MARKET REGULATION SHOULD CONSIDER
THE ELIMINATION OF THE RESTRICTED OPTION RULES
AS SOON AS THE OVERALL EFFECTIVENESS OF THE OPTIONS
STUDY'S SUITABILITY RECOMMENDATIONS CAN BE EVALUATED.

3. Selling Practices
To examine the manner in which options transactions are recommended
to public customers, the Options Study reviewed public complaint

letters, retail sales practice examinations conducted by the Commission
and the self-requlatory organizations and additional data, including the
responses to a detailed questionnaire, provided by broker -dealers.
Significant problems related to options selling practices were found.
These problems included solicitation of options transactions unsuited
to the customer; excessive and unauthorized trading in customer options
accounts; inadeouately trained registered representatives and supervisors;
deceptive advertising and sales literature; and irregularities in
options exercise practices.

a. Customer Protection
Both brokerage firms and self -regulatory organizations need to
improve their procedures to prevent sales practice abuses. As a first
step, broker -dealers and the self-regulatory organizations should
take steDs to place the customer in a better position to detect sales
practice abuses in his own account. If the customer does not have
in his possession essential information about his own account in a
form he can easily understand, the customer can not detect and prevent
improper activities in which his registered representative might engage.

1) The OCC Prospectus
One of the major regulatory safeguards intended to protect options
customers from possible abuses is a prospectus required by the Securities
Act of 1933 ("Securities Act"). Tne options prospectus is published

by the Options Clearing Corporation ("OCC"), which technically is
the issuer of all listed options. Exchange rules require that
this prospectus be delivered to every customer at or prior to the
time his account is approved for options trading. The prospectus
contains 56 orinted pages describing, in considerable detail, information
about options, their risks and the mechanics of options trading.

The current options prospectus was drafted to meet the requirements
of the Commission's general registration form, Securities Pet Form
S-l. This form is used when no other specialized form has been designated.
While the OCC has gone to considerable effort to simplify the language
of the options prospectus, the Form S-l is not designed to meet the
needs of both options buyers and sellers. The Options Study has
concluded that information concerning listed options should be dis-
closed to investors in a manner readily understandable to a reader
with no financial training and that information about options and
the trading markets for options should be separated from information
about the OCC.

Compliance by the OCC with the Securities Act can be satisfied
by the filing of a special form of registration statement and
orospectus designed for OCC as the issuer of options and adopted
nursuant to the Commission's authority under the Securities Act.
This soecial form would include information relating to the OCC,
including a description of its business and financial reports.

40-940 O - 79 - 6

To provide investors with an appropriate disclosure document,
a new document prepared by OCC would be required under the Exchange
Act to be delivered at or prior to the time of an options customer
opens an account. This document, designed for persons without
financial training, would provide investors with a simple descrip-
tion of the risks and uses of put and call options. This new
document should include a glossary of terms; a description of
(i) the risks of options trading, (ii) the fundamental uses of
options trading, (iii) the terms of options, and (iv) the mechanics
of buying, wiring and exercising options; and a simplified dis-
cussion of transaction costs, margin requirements and tax consequences
of option trading.

The effect of these recommendations would be to relieve OCC
from liability under Section 11 of the SEcurities Act for disclosures
relatina to a description and uses of options and the mechanics
of the ootions trading markets, matters with respect to which OCC
has no special expertise or control. At the same time, potential
options traders would be furnished with a disclosure document de-
siqned specifically for their needs and, in particular, for the needs
of those investors with little or no financial training.

Accordingly, the Options Study recommends.

FILED UNDER TOE EXCHANGE ACT DESCRIBING OPTIONS, THEIR
RISKS, AND THE MECHANICS OF OPTIONS TRADING BE PREPARED
BY OCC AND BE DELIVERED BY BROKER-DEALERS TO EACH OPTIONS
CUSTOMER AT OR PRIOR TO THE TIME THE CUSTOMER OPENS AN
OPTIONS ACCOUNT.

2) Customer Suitability

Another safeguard designed to protect the customer from unethical
or illegal selling nractices is the brokerage firm's own evaluation of
the customer's suitability to trade in options. The self-regulatory
organizations have adopted rules establishing suitability standards
which are to be aoplied by broker-dealer firms to prevent the firms
and their registered representatives from making unsuitable recom-
mendations to customers. The suitability rules of the options exchanges,
however, do not match the suitability warning in the prospectus.

The current options prospectus states on the cover page in

bold face type :

Both the purchase and writing of Options involve
a high deqree of risk and are not suitable for many
investors. Such transactions should be entered into
only by investors who have read and understand this
prospectus and, in particular, who understand the
nature and extent of their rights and obligations
and are aware of the risks involved.

The options exchanges do not require, as does the prospectus, that

the customer understand the risks of recommended options transactions,

except when the particular recommendation is to write (sell) uncovered

calls or to write put options.

This important distinction can be seen in the general suitability

rule of the CBOE. This rule, which is similar to those of the other

options exchanges, requires only that a registered representative

who recommends options transactions to a customer:

shall have reasonable grounds for believing
that the recommendation is not unsuitable
for such customer on the basis of the
information furnished by such customer after
reasonable inauiry as to his investment
objectives, financial situation and needs,
and any other information known [to the
broker-dealer firm or registered representa-
tive] . (Emphasis added.)

Only when the registered representative's recommendation is to write

uncovered call or put options does the CBOE rule require that the

customer should understand the risks involved, thder this paragraph

of the rule, writing uncovered calls or writing puts is deemed unsuitable

unless:

upon the information furnished by the customer ,
the person making the recommendation has a
reasonable basis for believing at the time of
makinq a recommendation that the customer has
such knowledge and experience in financial
matters that he may reasonably be expected to be
capable of evaluating the risks of such transac-
tion, and such financial capability as to be
able to carry such position in the option contr ac t .
(Emphasis added.)

The Options Study believes that a customer should be made aware,
on an on-ooing basis, of the risks of any and all options transactions
undertaken by the customer and that a brokerage firm should not be per-
mitted to recommend any opening options transaction to a customer unless

the firm reasonably expects that the customer is capable of both
evaluatinq the risks and bearinq the financial burden of those risks.

lb insure that this standard is met on a continuing basis, infor-
mation concerninq a customer's current financial resources, needs,
and sophistication should be obtained by the brokerage firm. This
information should be utilized in determining the suitability of options
trading for a customer, first at the time a customer opens an account
and again before a registered representative recommends a new, more
comolex, or riskier options strategy than the type for which the
customer has already been approved.

Without accurate and complete data about a customer's financial
oosition and objectives, a brokerage firm cannot make well founded
decisions concerning the suitability of options trading for that
customer. Too often, a registered representative, without detection,
fabricates suitability information about prospective new options customers
solelv in order to secure from his supervisor the required approval
of transactions for an account. The State of Wisconsin has resolved
this oroblem by requiring that the management of a brokerage firm
send to each new optior ^er a copy of the completed suitability

information form relating chat customer. This process assures the
customer an opportunity to review the information form, outlining
his financial objectives and position, which the registered repre-
sentative has already filled out.

accordingly, tne Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD REVISE
THE1K OPTIONS SUITABILITY RULES TO PROHIBIT
A tiROKER-DEALER PROM RECOMMENDING ANY OPENING
OPl'IONS TRANSACTIONS TO A CUSTOMER UNLESS THE FIRM HAS
A REASONABLE BASIS FOR BELIEVING THAT THE CUSTOMER
IS AbLE TO EVALUATE THE RISKS OF THE PARTICULAR
RECOMMENDED TRANSACTION AND IS FINANCIALLY ABLE
TO BEAR TBE RISKS OF THE RECOMMENDED POSITIONS.
THE BELF-REGULATORY ORGANIZATIONS SHOULD FURTHER
AMEND THEIR RULES TO REQUIRE:

— THAT CUSTOMER INFORMATION FORMS BE STANDARDIZED
AND REVISED TO INDICATE THE SOURCE OF SUITABILITY
INFORMATION ABOUT THE OPTIONS CUSTOMER;

— THAT THE MANAGEMENT OF EACH MEMBER FIRM SEND TO
EVERY NEW OPTIONS CUSTOMER FOR HIS VERIFICATION
a COPY OF THE FORM CONTAINING THE CUSTOMER'S
SUITABILITY INFORMATION AND 'THAT 'THE CURRENCY OF
INFORMATION ON SUCH FORMS BE CONFIRMED SEMI-
ANNUALLY;

— THAT MEMBER FIRMS BE PROHIBITED FROM RECOMMENDING
OPENING OPTIONS TRANSACTIONS 'TO CUSTOMERS WHO REFUSE
TO PROVIDE SUITABILITY INFORMATION, AND FOR WHOM THE
FIRMS DO NOT OTHERWISE HAVE INDEPENDENTLY VERIFIED IN-
FORMATION SUFFICIENT FOR THE SUITABILITY DETERMINATION; AND

— THAT MEMBER FIRMS ADOPT ADDITIONAL SAFEGUARDS FOR THE
PROTECTION OF EACH OPTIONS CUSTOMER IN WHOSE ACCOUNT
DISCRETION IS TO BE EXERCISED.

3) Opening Account Statements
Even it a customer is aDie to understand the risKs of his options
transactions, he may be contused by his account statement. Account
statements reflecting options transactions sent by brokerage firms
to tneir customers are frequently difficult to understand. Not only
may a customer nave aitticulty understanding the options transactions

reported in his statement, he may also have difficulty determining

whether he has earned a profit or sustained a loss. In certain

cases, even the customer's registered representative has been unable

to calculate the customer's profit or loss on the basis of the account

statement.

Moreover , most firms do not provide account statements which

state clearly the' individual conmissions charged on each transaction

or summarize the commission charges for the period covered. Nor do

these account statements show the customer the current equity in his

account after valuing all the customer's positions at current

"marked-to-market" prices, although a few firms have begun recently

to calculate this figure for their customers, lb add to these omissions,

account statements do not indicate the amount of certain other expenses.

Such information is essential for the customer when he attempts to

evaluate the financial consecuences of his options transactions.

Accordinglv, the Options Study recommends:

THE SELF -REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES REQULRING THE OPTIONS CUSTOMER'S ACCOUNT
STATEMENT TO SHOW THE EQUITY IN THE CUSTOMER'S
ACCOUNT WITH ALL OPTIONS AND SECURITIES POSITIONS
MARKED-TO-MARKET AND THE YEAR TO DATE PROFIT OR
LOSS IN THE ACCOUNT CLEARLY SHOWN. THE OPTIONS
CUSTOMER'S ACCOUNT STATEMENT SHOULD ALSO SHOW
THE AMOUNT OF MARGIN LOANS OUTSTANDLNG AS WELL
AS COMMISSION CHARGES APPLICABLE TO EACH TRANS-
ACTLON AND OTHER EXPENSES PAID OR PAYABLE FOR THE
PERIOD COVERED BY THE ACCOUNT STATEMENT AND YEAR
TO DATE.

b. Responsibilities of Broker-Dealer Firms
Brokerage firms are responsible for dealing with customers in
a fair, ethical and professional manner. To fulfill these respon-
sibilities to the greatest extent practicable, the Options Study
believes that firms must:

— assure that their registered representatives are properly
trained;

— establish and implement appropriate supervisory controls over
their registered representatives, including establishing
and implementing adequate programs for reviewing customer
accounts;

— compile and maintain adequate information and records about
the sophistication, needs and resources of each customer;
and

— assure that communications with the public - through
advertising or other means - are truthful and accurate.

1) Qualification of Registered Representatives
A primary obligation of a broker-dealer firm to its customers should
be the assurance that its registered representatives - the people who
have the most freouent and significant contact with public customers
- are properly trained and understand their business and responsibilities,
Inadeouate or inconsistent professional qualification standards
adopted and applied by the self -regulatory organizations and
broker-dealers, however, permit untrained registered representatives
to recommend options transactions to customers.

Options exchange rules require that all sales personnel be "options
Qualified" before they can service customer options accounts, but these
aualifyinq standards appear to be ineffective. In the first place, the
examinations now used to qualify both new and experienced registered
representatives to sell options are of questionable utility. The qualifying
examination given to a new registered representative can be passed by him
— at which point he may begin selling stocks and options — even if
he missed every question relating to options. The options qualifying
examination, qiven to an experienced registered representative who wishes
to begin to sell options, is not administered under controlled test
conditions to assure that the person does in fact know the answers he
is giving on the examination. In addition, although options exchanges
impose minimum traininq requirements for options qualification, these
reauirements are largely unenforced. Because of these inadequacies,
many registered representatives now servicing the accounts of options
customers may lack the necessary knowledge and skill to perform their
functions professionally and to fulfill their legal obligations.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO REQUIRE THAT: (A) THE REGISTERED
REPRESENTATIVE "OPTIONS QUALIFYING" EXAMINATIONS
SHOULD BE REVISED TO REQUIRE A THOROUGH
KNOWLEDGE OF OPTIONS AND THE OPTIONS EXCHANGE
RULES DESIGNED TO PROTECT CUSTOMERS. THESE
EXAMINATIONS SHOULD BE READMTNISTERED TO ALL
OPTIONS SALESPERSONS, AND ALL EXAMINATIONS
SHOULD BE GIVEN UNDER CONTROLLED SURROUNDINGS
BY INDEPENDENT EXAMINERS; AND (B) THE TRAINING

OF REGISTERED REPRESENTATIVES WHO RECOMMEND
OPTIONS TRANSACTIONS TO CUSTOMERS SHOULD BE
FORMALIZED TO INCLUDE A MINIMUM NUMBER OF HOURS
OF APPROVED CLASSROOM AND ON-THE-JOB INSTRUCTION.

2) Supervision of Registered Representatives
and of Customer Accounts

The oroblems caused by an untrained sales force may be exacerbated
by unoualified supervisors and by inadequate supervision. According
to the existing rules of the options exchanges, new customer accounts
must be approved for options trading by an officer of the firm
who has passed an advanced test - the registered options principal
("ROP") examination. But these same rules do not require that
each sales office be supervised by a person who is qualified as
an ROP although these sales offices may be recommending and effecting
options trades. In many firms, in fact, the supervisor of a sales
office is not so qualified. The ROP qualification examination is
deficient in that it concentrates on the mechanics of listed options
rather than the responsibilities of supervisors. Furthermore, some
ROPs have never passed a qualifying examination controlled by independent
examiners. As a consequence , the day-to-day conduct of the options
business at the branch level of many firms is supervised by individuals
who may have little, if any, understanding of options trading.

The Options Study also found substantial inadequacies in the
systems that broker-dealer firms use to oversee the activity in customer
accounts. In numerous instances, firm employees themselves have circum-

vented these systems. For example, options exchange rules require,
as a means of control, the initialing of discretionary orders
by a branch manager. This responsibility, however, is sometimes
delegated to a particular registered representative who himself
needs to be controlled. Supervisory problems can multiply when a
salesman is considered "special." For example, where a firm's computer
identifies potential problems in an account, branch managers and
other supervisors too often fail to take action because the registered
representative involved is a "big producer" of commission revenue.

Mother flaw in supervision can occur because many firms
are sometimes unable or unwilling to compile current, accurate
information about the status of their individual customer accounts.
Deprived of this information, a supervisor's ability to focus quickly
on critical problems in his own office is significantly curtailed.

Accordinglv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO REQUIRE THAT: (A) THE ROP QUALIFICATION
TEST BE REVISED AND ALL ROPS BE REQUIRED TO
TAKE THE REVISED TEST UNDER CONTROLLED CONDITIONS ;
(B) THE PRINCIPAL SUPERVISOR OF ANY BRANCH OR
OTHER OFFICE ACCEPTING CUSTOMER OPTIONS TRANS-
ACTIONS SHOULD BE QUALIFIED AS AN ROP; (C) EACH
FIRM DESIGNATE A POLICY LEVEL OFFICIAL WHO,
ABSENT A CLEAR SHOWING OF COMPELLING CIRCUMSTANCES,
HAS NO SELLING FUNCTION TO OVERSEE THE FIRM'S
OPTIONS COMPLIANCE PROGRAM; (D) THE SELF -REGULATORY
ORGANIZATIONS DEVISE A UNIFORM SYSTEM OF SUPER-
VISORY PROCEDURES FOR FIRMS OFFERING OPTIONS
TO PUBLIC CUSTOMERS; (E) THE HEADQUARTERS OFFICE
OF EACH BROKER-DEALER ACCEPTING OPTIONS TRANSACTIONS
BY CUSTOMERS SHOULD BE IN A POSITION TO REVIEW
EACH CUSTOMER OPTIONS ACCOUNT ON A TIMELY BASIS
TO DETERMINE:

COW ISS IONS AS A PERCENTAGE OF
EQUITY IN A CUSTOMER'S ACCOUNT;

UNUSUAL CREDIT EXTENSIONS;

REALIZED AND UNREALIZED LOSSES IN
EXCESS OF AN ESTABLISHED PERCENTAGE
OF THE CUSTOMER'S EQUITY;

UNUSUAL RISKS OR UNUSUAL TRADING
PATTERNS IN A CUSTOMER'S ACCOUNT;

3) Recordkeeping and Communications with Customers
Additional problems in the area of customer accounts arise because
manv firms fail to maintain adequate records concerning their customers
and their communications with customers. These records should include
materials relating to: information about the customer's general back-
qround , financial needs, and investment objectives; any complaints
the customer may have expressed orally or in writing; the method of
allocating exercise notices to customers; and copies of worksheets
and Derformance reports which registered representatives send to their
customers in conjunction with options recommendations.

Customer complaints are frequently not available to the management
at a firm's headquarters because some firms keep them on file only at the
branch office which originally gave rise to the complaint. As a result,
it is difficult for the headquarters office to ascertain developing
branch office problems. On the other hand, some firms maintain customer
suitability information only at the headquarters office and do not
maintain copies at the branch office for use by local supervisors.

The Quality and accuracy of other forms of broker-dealer communica-
tions with the public often fall below acceptable standards. For example,
the Quality of options advertising and sales literature vary significantly
from firm to firm and these materials too often contain misleading
or inaccurate statements. Several options seminar scripts, prepared
bv the brokerage firms themselves, were found to be similarly
flawed .

lacking sufficient supervision, registered representatives are
often at liberty to send worksheets to their customers which detail
oromising returns on recommended options transactions. Worksheets
are freouently included as part of a promotional package, along
with performance reoorts of the particular firm's options program.
The Options Study has found that these worksheets and reports are
freauentlv inaccurate and that worksheets sometimes contain only
overly optimisl rejections of return which mislead customers.

Copies of these documents, which can be useful in detecting improper
sellinq oractices, are often not maintained for review by the firm.

Accordingly, the Cot ions Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RECORDKEEPING RULES WHICH REQUIRE THAT MEMBER
FIRMS: (A) KEEP COPIES OF CUSTOMER COMPLAINTS,
CUSTOMER SUITABILITY INFORMATION AND CUSTOMER
ACCOUNT STATEMENTS AT BOTH BRANCH OFFICES AND
THE HEADQUARTERS OFFICE; (E) KEEP COPIES OF ALL
WORKSHEETS, PERFORMANCE REPORTS AND OTHER COM-
MUNICATIONS BETWEEN REGISTERED REPRESENTATIVES
AND THEIR CUSTOMERS, AND IMPROVE SUPERVISION OVER
THE USE OF THESE SELLING DOCUMENTS; AND (C) KEEP
RECORDS CONCERNING RATES OF RETURN ON INVESTMENT
QUOTED TO OPTIONS CUSTOMERS AND IMPROVE SUPERVISION
OF AND DISCLOSURE CONCERNING OPTIONS PROGRAMS AND
SEMINAR PRESENTATIONS.

4) Exercise Allocations

Finally, the Options Study observed several instances of misalloca-
tion of exercise notices by broker-dealers, including situations in which
firm practices concerning customers' exercise allocations have resulted
in iniury to public customers. Some firms did not have, or could not
Drovide, records which disclosed the method by which exercise notices
were assigned. For this reason, it was sometimes impossible to
determine satisfactorily whether all firms have been following
options exchanqe rules regarding the allocation of exercise
notices. A uniform allocation system, coupled with consistent
recordkeeping reauirements, would prevent unfairness in the
allocation process and make the detection of irregularities in the
exercise oractice of broker-dealers easier.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
ESTABLISH A UNIFORM EXERCISE ALLOCATION
PROCEDURE AND SHOULD REQUIRE THAT MEMBER
FIRMS KEEP RECORDS WHICH ARE ADEQUATE
TO PERMIT REVIEW OF EXERCISE ALLOCATION
PRACTICES.

4. Financial Structure

The Ootions Study examined the financial structure of the
options market to determine whether sufficient safeguards and con-
trols exist to protect the market place and, ultimately, the public
from being harmed by the financial failure of either broker -dealers

carryina public customer or other broker-dealer accounts or broker -dealers
on the floor of an exchanqe with market making responsibilities.
These safequards and controls include: (1) the Commission's net
caoital and customer protection rules; (2) the Commission's and SFO's
financial reportinq and early warning requirements; (3) the Federal
Reserve Board ("FRB") initial margin requirements and self -regulatory
maintenance margin requirements; (4) the Securities Investor Protection
Corporation ("SIPC") protections; and (5) the OCC financial requirements
and marqin requirements. After reviewing these safeguards and controls,
the Options Study has concluded that numerous steps should be taken
to make these safequards more responsive to the risks associated
with options positions without imposing substantial additional net
caoital requirements on market participants.

a. The Commission's Net Capital Rule
The Commission's net capital rule requires that broker -dealers
maintain a sufficient cushion of liquid assets to satisfy all customers'
claims. It establishes minimum net captial requirements ranging from
$2,500 to $100,000, depending on the nature of the firm's business,
with broker -dealers that carry customer accounts subject to a minimum
$25,000 requirement. In very general terms, net capital equals
net worth less (1) non-liquid assets and (2) a deduction (called
a "haircut") which reflects the general market risk for securities,
ranging from 1/8 percent for commercial paper to 30% of the market

value for common stock. This rule also contains provisions limiting

a broker-dealer 's volume of business in relationship to its net

capital. With respect to options, the net capital rule limits the

amount of business an OCC member can finance and guarantee for specialists,

competitive marketmakers or registered options traders who trade

on the floor of an options exchange ("market makers"). More specifically,

the rule limits the gross deductions for positions in marketmaker

accounts to ten times the OCC member's net capital.

1) Increase of Deductions in Computing Net Capital
Eased on computer analysis and impact studies of data requested,
the Ootions Study found that existing financial safeguards provide
sufficient capital to protect both the market and public investors
in periods of normal volume and price movements. The Options
Study is concerned, however, that these financial safeguards with
respect to OCC member clearing firms that carry the accounts of options
marketmakers may be inadequate during times of abnormal volume
and price surges. The amount of deductions currently required
in computing a clearing firm's net capital appears inadequate in
three areas: (1) deductions for options exercisable at prices
near or at the current market price of the underlying security
("near" or " at-the-money" options) which are subject to volatile
percentage price movements; (2) gross deductions for marketmaker

positions carried by a clearing tirm in relation to its net capital

to limit tne volume ot clearing Dusiness that can be done; and

(J) lacK ot deductions to recognize tne additional risks of market-

maxer accounts carried oy an OCC member clearing firm holding

in tne aggregate in excess of 10 percent of the outstanding open

interest in any one options class ("concentrated positions").

Accordingly, tne Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET capital RULE TO:

— increase the deduction in computing net capital
eok neak ok at-the-money options by providing
that the deductions for short options positions
in marketmaker accounts be ecjual to the
greater of (l) 75 percent of the premium value,
(11) §75, or (hi) 5 percent of the market
value of the underlying stock reduced by

the amount by which the exercise price of the
OPTION VakIeS from the current market price
FOR THE STOCK.

— REDUCE the permissible amounts of gross deductions

TO NET CAPITAL, RESULTING FROM THE OPTIONS AND
STOCK POSITIONS CARRIED BY A CLEARING FIRM FOR
MARKETMaKERS.

— KEOUIRE AN ADDITIONAL CHARGE IN AN OCC MEMBER'S
COMPUTATION OF ITS NET CAPITAL FOR ANY NET LONG
OK NET SHORT1 OPTIONS POSITIONS IN ALL MARKET-
MAKER ACCOUNTS GUARANTEED BY THE OCC MEMBER
WHICH ARE IN EXCESS OF 10 PERCENT OF THE OPEN
INTEREST IN THE OPTIONS CLASS. THIS DEDUCTION
SHOULD BE EQUAL TO AN ADDITIONAL 50 PERCENT

OF THE CHARGE OTHERWISE REOUIRED FOR EACH
SERIES IN THAT OPTIONS CLASS.

40-940 O - 79

2) Net Capital Deductions for Marketmaker
Clearing Business"

The net capital deductions that result from transactions in market-
maker accounts carried by a clearing firm must be made on the same day
the transactions occur, although these transactions do not clear until the
next dav. Although this requirement was adopted with an understanding
that options transactions clear the next business day, it results in
a clearing firm having to maintain a net capital position in anticipation
of these charaes. Typically, the net capital deduction for other securi-
ities transactions by broker -dealers, however, is not made until the
day the transaction normally clears (settlement date). For example,
no charge is made to net capital on the purchase of stock by a broker-
dealer until settlement date, generally five business days after
the purchase. The Options Study has concluded that the clearing firms
should have until the next business day after their marketmaker charges
arise to make the required net capital deduction and, if necessary, to
out additional capital into the firm or to obtain additional capital
from their marketmakers. This change in the net capital rule would
not relieve a non-clearing marketmaker of his responsibility to have
equity in his account at the end of each day.

While this recommended change may have the effect of reducing
the amount of net capital clearing firms must maintain on a regular
basis, other recommendations of the Options Study will increase

their net capital reauirements and affect the timing of net capital

deductions to make them more sensitive to particular options risks.

Accordinqly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO PERMIT A CLEARING FIRM
ONE BUSINESS DAY TO OBTAIN ADDITIONAL CAPITAL
OR MARKETMAKER EQUITY BEFORE MEETING THE NET
CAPITAL DEDUCTIONS ARISING OUT OF ITS MARKET-
MAKER CLEARING BUSINESS.

3) Marketmaker Minimum Net Capital

The 1975 amendments to the Exchange Act required that all
broker -dealers, includinq marketmakers not carrying public customer
accounts, be subject to financial responsibility requirements. Options
marketmakers which do not clear their own transactions and do not
carry nublic customer accounts currently are subject to financial
resoonsibility rules adooted by the options exchanges but are exempt
from the Commission's net capital rule.

In September 1977, the Commission's Division of Market Regulation
recommended to the Commission that it propose for public comment a
reauirement that these currently exempt marketmakers have a minimum equity
of $25,000. Although this proposed rule was not published for comment,
the Options Studv has since found that on March 31, 1978 (prior to
marketmaker losses during the April 1978 market surge), 498 of the
86 5 marketmakers on all options exchanges did not have $25,000
ecruity in their account. Of these, 279 had less than $5,000 equity
in their accounts.

The Ootions Study's data does not indicate that a $25,000 minimum
financial responsibility test need be required. An analysis was made
by the CBOE and Options Study staffs of data from two OCC member firms
clear inq marketmaker accounts which failed to comply with the Commission's
net capital rule for one day during the April 1978 market surge. This
analysis showed that less than 1 percent of the decline in net capital
at one firm resulted from markemakers with equity of less than $25,000
while at the second, these accounts were the cause of only 30 percent of
the OCC member's net capital decline. From this analysis it was concluded
that the difficulties encountered by the two OCC members were not caused
by marketmaker accounts which had only a small equity.

In view of the directives contained in the 1975 amendments to
the Exchanqe Act, the Options Study believes that the marketmakers
should be required to have a minimum equity similar to that required
under the net capital rule for other broker-dealers not carrying
public customer accounts, currently $5,000. The Options Study believes
this reouirement will add financial responsibility to the marketmaker
system without unnecessarily impeding entry into the business.

Accordingly, the Ootions Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO REQUIRE MARKETMAKERS THAT
DO NOT CARRY CUSTOMER ACCOUNTS OR CLEAR TRANS-
ACTIONS TO MAINTAIN A MINIMUM EQUITY OF $5,000.

4) Financial Requirements of Upstairs Dealer Firms

The financial requirements applicable to the options business

of broker-dealer firms that trade off the floor of an exchange ("upstairs

dealers") are substantially different from those established for a clearing
firm carryinq marketmaker accounts. The requirements for clearing
firms' short options positions recognize that a liquid market exists
where listed options are bought and sold at regularly quoted prices.
The parallel requirements for upstairs dealers, on the other hand,
are based on the assumption that no secondary market for the options
exists and that the options will inevitably be exercised. In addition,
the net capital rule requires upstairs dealers to treat certain options
positions separately even thouqh these options positions offset the risks
of other options positions held at the same time. This risk limiting
feature of certain options strategies, however, has been recognized
to some extent in the net capital rule for clearing firms carrying market-
maker accounts.

While the net capital approach to upstairs dealers may have
been approoriate when adopted because the development of the
listed options market was still uncertain, it places unnecessary
financial restrictions on the ability of the upstairs dealers
to participate in the listed options market today. The Options
Studv believes that the Commission's net capital rule should be
revised to take into account the marketability of listed options
and the risk limiting feature of certain options strategies in
establishing the financial requirements for upstairs dealers.
These upstairs dealers would still be subject to more stringent

financial reouirements overall than marketmakers and this revision

would not adversely impact on the protections afforded by the

net capital rule.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS

NET CAPITAL RULE TO ESTABLISH REQUIREMENTS

FOR UPSTAIRS DEALERS THAT TAKE INTO CONSIDERATION

THE EFFECTS ON RISK OF SPREADING STRATEGIES

IN LISTED OPTIONS AND THE EXISTENCE OF A SECONDARY

MARKET IN OPTIONS.

5) Marketmakers that are OCC Members

In June 1977, the Commission's net capital rule was amended
as it applied to an OCC member which limited its business to acting
as a marketmaker for its own account and to carrying the accounts
of other marketmakers. The rule as modified permitted these firms
to apply the same limited "haircut" deductions to their options and
stock positions under the net capital rule as those required for
marketmaker accounts being cleared through an independent clearing
firm.

Prior to this amendment, such OCC members having an equity
interest in a marketmaker account were subject to the more onerous
"haircuts" applicable to upstairs dealers. The effect of the change
was substantial. For example, the net capital deduction required of
an upstairs dealer on selling an uncovered call option is 30 percent
of the value of the stock underlying the option with a minimum charge

of $250 for each options contract. If the same position is held
by a marketmaker , the deduction is 75 percent of the market value of
the ootion with a minimum charge of $75 for each options contract.

The options and stock positions of the marketmaker carried
by an independent firm are subject to arm's-length negotiated
review by that independent firm as part of the latter' s effort
to orotect its financial interest as a creditor of the market-
maker accounts it carries. This safeguard, however, is lacking
when a clearing firm is tradinq in options on the floor of an
exchange for its own account or is clearing an account in which
an affiliated person has an ownership interest.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE SO THAT THE CAPITAL REQUIRED
FOR ALL OF THE POSITIONS IN AN ACCOUNT IN WHICH
A CLEARING FIRM, ITS OFFICERS, PARTNERS, DIRECTORS
OR EMPLOYEES MAINTAIN A FINANCIAL INTEREST ARE IN-
CREASED. THIS MAY BE ACCOMPLISHED BY REQUIRING THAT
SUCH ACCOUNTS MEET THE SAME FINANCIAL REQUIREMENTS
THAT ARE APPLICABLE TO UPSTAIRS DEALERS.

b. Options Specialist Stock Credit
Federal Reserve Board ("FRB") margin requirements effectively
limit the credit that may be extended by a clearing firm to a
marketmaker to 75 percent of the value of stock underlying options
positions, orovided that the exercise price of the option is
not more that 5 percent greater than the current market price

of the stock in the case of calls, or 5 percent less in the case

of puts ( "out-of-the-money" options). Ihe remaining 25 percent must

be deposited by the marketmaker with his clearing firm if the stock

position is carried for more than five businss days after purchase.

If an underlying stock position is sold within five days, the marketmaker,

unlike public customers, is not required to make any margin deposit

on the stock with his clearing firm. Certain marketmakers have

made a practice of selling their stock within this five-day period

and then immediately repurchasing the stock to retain their position

without the necessity of putting up a margin deposit. The Options

Study does not believe this type of activity contributes to an

orderly market or to the financial integrity of the options market.

1) Stock Hedge
Marketmakers frequently need to hedge the risks of their options
positions with stock, particularly when the market in a suitable off-
setting call or put is not sufficiently liquid or if puts are not
available. The Options Study believes that credit provisions should
be revised to permit the options marketmaker to finance his bona
fide hedging stock transactions through his clearing firm without
making a mar q in deoosit ("good faith credit basis") even if the
option is out-of-the-money. This type of financing is herein
called "Specialist Stock Credit." The amount of Specialist Stock
Credit that should be available to the marketmaker through his

clearinq firm, however, should be carefully defined to avoid
Soecialist Stock Credit being used to finance stock speculation.

Two steps need to be taken. First, Specialist Stock Credit avail-
able to the options marketmaker through his clearing firm should
be strictly limited to finance no more than that number of shares for
which any increase or decrease in the price of the underlying stock
would be offset by an equivalent or greater decrease or increase in the
market value of the hedged options position. In this way, the market-
maker will be unable to use this Specialist Stock Credit to speculate
in stocks underlying listed options because any gain or loss on the
stock most probably would be offset by the loss or gain on his
options positions.

To determine whether a stock position represents a bona fide hedge
of the risks of an options position, the ratio of expected stock to
options or ice movements can be calculated usinq a mathematical
formula based upon: (1) the current risk free interest rates (United
States qovernment securities); (2) the exercise price of the options;
(3) the market price of the stock; (4) the time to maturity of the
options; and (5) the volatility of the stock computed from past stock
or ice movements. This formula can be used to predict the number of
shares of stock necessary to offset price movements in related options
and is called an options pricing formula. Various pricing formulas
are currently used by most marketmakers, and by clearing firms granting

them credit, to determine the equivalent share risk exposure of an options,
or options and stock, position; however, a uniform rule should be adopted
for determininq the Specialist Stock Credit hedge ratio.

Any position in an underlying stock obtained or retained in a market-
maker account in excess of that necessary to hedge an options position,
or any stock oosition that did not underly a cualified options position,
should be immediately subject to full initial and maintenance margin
requirements.

A position in an underlying stock may be a bona fide hedge
at the time the stock is acquired but, due to a change in the delta
hedge ratio resulting from stock price movements, the underlying
stock position may exceed the amount permitted to be carried on a
good faith credit basis, m this event the options marketmaker
should be permitted to promptly liquidate his excess stock position
or adjust his options position to a hedge position, rather than
being required to make a margin deposit.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER RECOMMENDING
TO THE FRB THAT CLEARING FIRMS FOR MARKETMAKERS
BE PERMITTED TO FINANCE POSITIONS IN A STOCK
UNDERLYING A MARKETMAKER OPTIONS POSITION
ON A GOOD FAITH CREDIT BASIS PROVIDED THE
SPECIALIST MARKETMAKER' S SPECIALIST ACCOUNT
CONTAINS ONLY THOSE SHARES NECESSARY TO HEDGE AN
OPTIONS POSITION, AS DETERMINED IN ACCORDANCE
WITH AN APPROPRIATE OPTIONS PRICING FORMULA.

2) Limit on Stock Qualifying for Specialist
Stock Credit

The second step that should be taken to control Specialist
Stock Credit is to limit the Specialist Stock Credit available
throunh clear inq firms to a stock underlying a limited number
of options classes in which a marketmaker can reasonably be expected
to use his capital actively. All marketmakers are currently
subiect to the same credit rules with respect to stock underlying
any class of options listed on the exchange where they are floor
participants.

The Cot ions Study recognizes that the competitive marketmaker
system was designed to allow flexibility in order to permit competing
marketmakers to move their activities into different classes of
ootions as changing market conditions required and for that reason
the Cot ions Study is not recommending any change in the margin
rules applicable to marketmakers for options transactions.
Nevertheless, based on a review of the number of classes of options
in which the most active CBOE marketmakers had stock positions,
the Options Study has concluded that Specialist Stock Credit should
be limited to stock underlying no more than 20 classes of options
at any one time plus such additional classes of options as a market-
maker has been asked to maintain a market by exchange officials
to meet unusual options activity. This number , however , should
be periodically reviewed to assure that Specialist Stock Credit

is being used properly and that this limit does not unduly interfere

witn the market making process. The marketmaker should be required

to register in advance in those options in which he expects to

be eligible for Specialist Stock Credit except in cases of specific

exchange approval.

Accordingly, the Options Study recommends:

THE OPriONS EXCHANGES SHOULD REVISE THEIR RULES
TO RESTRICT THE ABILITY OF* MARKETMAKERS TO
OBTAIN SPECIALIST STOCK CREDIT TO STOCK
UNDERLYING NO MORE THAN 20 OPTIONS CLASSES,
WITHOUT SPECIFIC EXCHANGE APPROVAL.

5. Market Structure

The Options Study also examined some of the major issues of market
structure in the standardized options markets. These issues include (i)
the multiple trading of standardized options, (ii) the integration of trading
of standardized options and their underlying securities, (iii) whether,
and under what circumstances, standardized options should be traded in
the over-the-counter markets, (iv) whether, and under what circumstances,
the trading of standardized options should be permitted on the New York
Stock Exchange, and (v) steps that tne Commission should consider at this
time to assure that the standardized options markets evolve in a manner
that is consistent with the establishment of a national market system.

The Options Study Report discusses these issues with a view toward
developing an analytical framework within which they may be evaluated.
The Options Study does not present specific recanmendations with respect
to whether the Commission should approve or disapprove any particular
rulemaking proposal.

Chapter II

FUNDAMENTALS OF EXCHANGE TRADED OPTIONS

A. CHARACTERISTICS OF OPTIONS

1 . Conventional OTC Options Compared to Listed Options
For many years options on stocks were sold only in the over-
the-counter ("OTC") market. The terms of these options contracts
— often called conventional or OTC options — were negotiated and
entered into between the individual buyer and seller through
broker-dealers with performance guaranteed by a NYSE member
broker-dealer. Generally, the conventional OTC option remained
outstanding until expiration because the individualized nature
of the conventional OTC options contract made trading these options
costly and difficult. Conventional OTC options are still being written
but the activity in these options has substantially declined with
the introduction of listed options trading.

Listed options differ from conventional OTC options in several
important ways including: 1) a liquid secondary market exists
for the trading of listed options; 2) transaction costs associated with
listed ootions are lower than those for conventional OTC options;
and 3) up-to-date quotations and transaction prices on listed
options are obtainable, during the trading day, through quotation and
price reporting services found in brokerage firms; and closing prices
are available through newsDapers.

(73)

The exercise rights of holders of conventional OTC options are
against the particular seller of the options. To close a position
in a conventional OTC option requires that either the original parties
cancel the contract or that a buyer be found for the previously
negotiated contract, a cumbersome and costly Drocess generally
transacted through brokers over the telephone. Closing transactions
in listed options are effected on an options exchange.

The secondary market in listed options is made possible
because all listed options contracts have standardized terms and
are issued and guaranteed by one organization, the Options Clearing
Corporation ("OCC"), which stands as intermediary between options
buyers and sellers. Because options contracts with standardized
terms are readily interchangeable, these contracts usually can be
traded with ease.

Although the OCC issues each listed option contract which
is bought and sold by options participants, it does not act as
a dealer. A listed option is created when a person makes a
sale of an option contract in an opening transaction. The obligation
of the seller of a call option to deliver stock upon payment of
the exercise price runs to the OCC, and the OCC is obligated to
pay him the exercise price if the option is exercised. The buyer
of a call option is obligated to pay the OCC the exercise price
if he chooses to exercise, and the OCC is then obligated to deliver
the underlying stock.

The seller of any option is commonly referred to as the writer
of the option contract and is said to be "short" the option. The
buyer is the holder of the option and is said to be "long" the
ootion. The original purchase or sale of a contract is an "opening"
transaction, because it opens up a new long or short position.
The subsequent buying back of an identical option, or the sale of
an option being held, -is referred to as a "closing" transaction.

For every opening sale transaction in listed options there is a
ourchase transaction. If a writer of an option wishes to close out
his position without awaiting exercise or expiration, he may do so
by buying, in a closing purchase transaction, an option identical
to the one he sold. Similarly, a holder of a listed option may
close out his long position by entering a closing sale transaction.
Because the OCC stands between writers and holders of options, there
is no need for an openinq writer to sell to an opening buyer. Instead,
an ooening writer may sell to a buyer closing out a short position.
At any given time, however, the total obligations of writers of
listed options owed to OCC are equal to the total obligations
of the OCC to holders of the listed options. Data from the CBOE
shows that on a cumulative basis from the inception of options
trading on that exchange in 1973 through the expiration of CBOE's
November 1977 series, 68.1 oercent of opening purchase transactions
in calls by holders other than marketmakers were closed in the course of

trading on CBOE, 5.1 percent _1/ were exercised and 27.1 percent were
allowed to expire (see Figure 1).

2« The Options Contract

A stock option gives the holder either the right to buy or the
right to sell a specified number of shares at a specified price
("strike price") of a designated underlying stock during the life
of the option. An option giving the holder the right to buy the
underlying stock is known as a "call option," because it gives
the holder the right to call upon the person who sold the option
to deliver the designated underlying stock upon payment of the
exercise price. An option giving the holder the right to sell
the underlying stock is known as a "put option," because it gives
the holder the right to put the underlying stock to the seller
of the option, and the writer is then obligated to pay the stated
exercise price for ,the stock. The most significant terms of an
option include the number of shares receivable or deliverable
on exercise of the option, which is usually 100 shares, the expiration
date, the underlying security and the exercise price. An option
"premium" is the amount of money that an option buyer pays and
an option seller receives for an option contract.

Listed option contract prices are quoted based on 1) the under-
lying security, 2) the expiration month and 3) exercise price. For
example, an IBM Jan 280 call option refers to an option to buy 100

1/ OCC data show that most exercises are for the account of member
firms.

/ /

MODE OF LIQUIDATIONS OF LONG POSITIONS*
IN CBOE LISTED OPTIONS

1973

-1977

Percent of Open

ing Purchases

Closing
Call

Sales
Put

Exercises

Expira

ition

Maturity

Call

Put

Call

Put

Group

Series

1973

July

73.3

—

7.9

—

16.2

—

Oct.

77.4

—

6.3

—

13.7

1974

Jan.

58.2

—

3.9

—

36.0

—

Apr.

59.6

—

3.7

—

33.7

—

July

49.9

—

0.6

—

48.2

—

Oct.

52.9

—

1.0

—

45.2

—

1975

Jan.

70.0

—

3.7

—

25.6

—

Apr.

84.8

—

7.5

—

6.7

—

July

71.4

—

4.2

—

23.3

—

Aug.

41.8

—

1.1

—

58.5

—

Oct.

73.1

—

4.8

—

23.6

—

Nov.

60.4

—

5.3

—

34.6

—

1976

Jan.

75.9

—

8.3

—

16.9

—

Feb.

80.1

—

7.2

—

11.2

—

Apr.

76.4

—

4.0

—

17.5

—

May

66.8

—

4.1

30.4

July

79.9

—

6.5

—

15.1

—

Aug.

61.1

—

4.9

—

35.2

—

Oct.

67.8

—

5.1

—

28.4

—

Nov.

55.7

—

6.4

—

39.2

—

1977

Jan.

68.8

—

5.6

—

26.3

—

Feb.

60.1

—

6.1

—

34.0

—

Apr.

55.0

—

3.8

—

41.8

—

May

61.3

—

8.1

—

31.0

—

July

66.4

—

5.8

—

28.3

—

Aug.

60.9

72.3

5.9

5.5

33.1

23.6

Oct.

58.5

82.1

3.1

4.4

38.4

10.9

Nov.

61.7

75.8

6.3

5.8

32.9

18.3

Expired Series

1973-1977

68.1

80.7

5.1

4.7

27.1

12.6

Data are for public customer and firm proprietary accounts. Marketmaker opening and closing
transactions are not distinguished for reporting purposes and are therefore excluded from the
table. Because of occasional coding errors, total liquidations (closing transactions, exercises
and expirations) do not necessarily equal opening purchases.

JRCE: CBOE Market Statistics, various issues.

40-940 O - 79 - 8

shares of IBM common stock at 280 per share (or an aggregate of
$28,000 plus transaction costs) until the following January. An
IBM April 280 call option would refer to the same rights until
the following April.

The rights and obligations under an option contract end on its
expiration date. The expiration time for listed options has been
standardized by the options exchanges and is 11:59 p.m. eastern time
on the Saturday following the third Friday in the month in which the
option expires. Options, however, cannot be purchased or sold after
the conclusion of trading rotations, which commence at 3:00 p.m. eastern
time on the business day before expiration in order to permit the OCC
to handle the exercise of expiring ootions. _2/ All listed options
of the same type — that is, either puts or calls — covering the same
underlying security are called a "class of options," and all options
of the same class having the same exercise or ice and expiration
date are called a "series of options."

Each class of options fits within one of three exoiration cycles
which establish the month in which the option contract will expire.
Tne three expiration cycles are as follows:

2/ For orocedures regarding tender of exercise notices, see OCC
Prospectus (October 16, 1978) at 28-29.

Expiration Cycle
February
May
August
November

Exoiration Cycle
March

June

SeDt ember
December

New series are generally created with a new expiration month
for a nine-month life when an old series expires. Consequently,
options for only three expiration months are outstanding at any
one time. The exercise price for a new series of options is fixed
in relation to the price of the underlying security at the time the
trading in the new series begins. Exercise prices are generally, but
not always, fixed at five-point intervals if the underlying security
is trading below $50 a share, at ten-point intervals if the underlying
stock is trading between $50 and $200 a share, and 20-point intervals
if the underlying stock trades above $200 a share. Generally, when
trading is to be introduced in a new expiration month an options
exchanae selects two exercise prices surrounding the then current
market price. For example, if the underlying security trades at
27, new series would be opened at 25 and 30. Additional new
series are also usually introduced whenever the price of the stock
moves up or down to the midpoint of the next appropriate 5, 10,
or 20-point interval from the exercise prices of existing contracts.

For example, the price of Bally Manufacturing Corporation stock,
which is listed on the NYSE, had traded between January and September 20

1978, at highly fluctuating prices ranging from a low of 15
per share to a high of 71-3/4 per share and closed, on September
20, 1978, at 40-3/8. On September 21, 1978, the Wall Street Journal
reported the following prices of Bally options on the CBOE. Due
to the stock's great price volatility during the year, new options
series were frequently added. Such fluctuations in the prices of
stocks underlying options, however, are rare occurences.

Bally Option Prices on CBOE on September 20, 1978
- Nov. - - Dec. - - May

Option Price

Vol.

Cost

Vol.

Cost

Vol.

Cost

Bally

..15

38-1/4

47-3/8

Bally

..20

33-1/4

47-3/8

Bally

..25

28-3/4

47-3/8

Bally

..30

47-3/8

Bally

..35

116

47-3/8

Bally

..40

193

11-1/8

20-1/4

47-3/8

Bally

..45

283

9-1/4

9-1/2

122

47-3/8

Bally

..50

1411

6-1/2

131

6-1/2

156

11-1/2

47-3/8

Bally

..60

2113

3-7/8

241

6-1/2

207

8-1/4

47-3/8

Bally

..65

3021

1-5/8

490

4-1/8

225

5-3/4

47-3/8

Price refers to the exercise price of the option.

Volume refers to the number of contracts traded on
September 20, 1978 in the particular option.

Cost refers to the premium or purchase price at which
an option traded on the CBOE on September 20, 1978
divided by the - of shares the option represented.

Close refers to closing price for Bally Manufacturing
stock on the NYSE c September 20, 1978.

a. - indicates the ootion was not traded on September 20,

1978

b. - indicates no option was offered.

3 . Stock Price Considerations in Listed Options

Options can be used as a substitute for short-term
stock trading and as a means of transferring certain of the risks and
potential rewards of short-term stock price movements from the options
seller to the options buyer. Various strategies can be used to accomplish
this:

An investor who believes a stock will increase in or ice can (1) buy
the stock; (2) buy a call; or (3) sell a put. An investor who believes
a stock will decrease in price can (1) sell stock short; (2) sell a
call; or (3) buy a put.

The buyer of stock benefits from any increase in price in excess
of his transactions costs and bears the full risk of loss in the event
of a market decline. Transaction costs include commission charges and
any interest that must be paid if stock is ourchased on margin. While
a call option buyer and a out option seller benefit from a stock price
increase, their risk and reward positions are different.

The call option buyer:

. Has the right to buy the underlying stock;

Does not profit until the price of the underlying
stock increases sufficiently to cover the premium
for the call option plus transaction costs;

Limits his risk of loss to premiums paid plus
transaction costs.

The put option seller:

Has the obligation to buy the underlying security
on exercise of the option

Limits his profit to the premium received on the
sale of the option, less transactions costs;

. Limits his risk of loss only to the extent of the
market price decline of the underlying security
during the life of the option, a portion of which
would be offset by the premiums received less trans-
action costs ('net premiums").

Similarly, the risk-reward positions of a call option seller and a

out option buyer are different in the event of a stock price decline.

The call option seller:

Has the obligation to deliver the underlying stock
on exercise of the option;

Limits his profit to the Dremium received on
sale of the options, less transaction costs;

Limits his risk of loss only to the extent that
the market price increase of the underlying
security during the life of the option is off-
set by the net premium received.

The put option buyer:

Has the right to deliver the underlying stock;

. Has profits only to the extent the price of
the underlying stock declines in an amount
greater than the premium for the out option
Plus transaction costs;

. Limits his risk of loss to the premium
paid plus transaction costs.

4 . Short-Term Character of Options Trading

Although listed options may have a maximum term of nine months,
most options are written for shorter terms. Indeed, the very short-
term horizon of ootion traders is evident from the distribution of out-
standing options — called open interest — and contract volume by

expiration month. Statistics for 1977 indicate that 50 to 60 percent
of open positions are in options with less than 3 months to expiration;
over 70 percent with less than 4 months and 90 percent with less than
6 months (see Figure 2). Similarly, over 60 percent of contract volume
usually appears to be in options with less than 4 months to expiration (see
Figure 3). Even greater concentration of interest and volume exists
for some individual classes of options. For example, data for Eastman
Kodak show that nearly 70 percent of May, 1978 volume in Eastman Kodak
options was in contracts expiring in June, 1978.

FIGURE 2

PERCENTAGE OF OPEN INTEREST IN EXCHANGE TRADED CALL OPTIONS
BY MONTHS TO EXPIRATION

1977

Months to Expiration
Less Than

3 Months 4 Months 5 Months 6 Months 7 Months 8 Months 9 Months

(Cumulative Percent)

Jan.

60.0

75.3

75.6

92.2

98.2

98.3

100.0

Feb.

62.0

62.4

83.6

92.6

92.8

99.1

100.0

Mar.

53.7

76.1

86.1

86.3

96.6

99.9

100.0

Apr.

56.7

71.0

71.4

90.0

96.9

97.1

100.0

May

56.9

57.6

80.8

91.1

91.5

99.1

100.0

Jun.

49.2

73.9

85.3

85.8

96.8

98.9

100.0

Jul.

57.0

72.7

73.5

91.0

97.1

97.5

100.0

Aug.

60.5

61.6

83.1

92.2

92.8

99.0

100.0

Sep.

54.3

77.5

87.6

88.3

97.3

100.0

Oct.

60.0

74.5

75.5

91.9

97.7

98.0

100.0

Nov.

61.7

63.0

84.2

92.8

93.2

99.3

100.0

Dec.

56.5

79.6

88.8

89.5

97.8

99.9

100.0

SOURCE: Options Clearing Corporation

FIGURE 3

PERCENTAGE OF CONTRACT VOLUME IN EXCHANGE TRADED CALL OPTIONS
BY MONTHS TO EXPIRATION

Months to Expiration
Less Than

1977

3 Months

4 Months

5 Months

6 Months

7 Months

8 Months

9 Months

(Cumulative Percent)

Jan.

37.0

70.4

80.3

80.6

93.6

98.1

98.3

Feb.

49.2

63.5

64.0

81.8

89.5

89.7

98.8

Mar.

51.0

51.6

73.7

82.2

82.4

94.9

99.9

Apr.

31.1

64.1

73.0

73.3

90.1

96.1

96.3

May

50.6

64.4

64.9

82.6

90.3

90.6

98.9

Jun.

53.4

54.6

76.2

84.5

85.1

95.8

99.7

Jul.

32.5

67.8

77.5

78.2

92.1

96.6

97.1

Aug.

52.3

66.4

67.2

83.7

91.0

91.5

98.7

Sep.

53.0

53.9

76.8

84.6

85.2

95.8

99.9

Oct.

33.4

67.8

76.3

77.0

92.1

97.2

97.5

Nov.

55.5

68.4

69.3

86.1

92.3

92.7

99.2

Dec.

57.8

59.7

80.9

87.2

88.1

97.0

99.9

SOURCE: Options Clearing Corporation

5 . Transaction Costs

The short-term nature of most options contracts means that trans-
actions costs can have a significant effect on the profitability of
options transactions. The listed options markets have substantially
reduced the transactions costs of trading options. A study by Black and
Scholes of conventional CTC options transactions for the period 1966-1969
concluded that transactions costs effectively reduced the rate of return
of call buyers from 33.3 percent to 8.3 percent. In contrast, the rate
of return of call writers was reduced only from 8.6 percent to 6.6 percent.
On the basis of this research they anticipated that if the options markets
could be made more efficient, and less costly for call buyers, the demand
for options would probably increase. 3/

Transaction costs are now substantially less in listed options
than they had been in conventional CTC options. In addition, listed
option transaction costs, if considered without regard to transaction
costs that may be incurred as a result of stock trading that is related
to ootions tradina, are less than the charges for trading stock in shares
ecruivalent to that covered by an option contract. Although competitive
commission rates mean that transactions can be entered into at different
charges at different firms, the published commission charges of ten large
retail brokers and one representative discount broker illustrate the current
costs of options trading as compared with trading directly in the stock
(see Figure 4) .

_3/ Black, Fischer, and Scholes, Myron, "The Valuation of Options
Contracts and A Test of Market Efficiency," The Journal of
Finance, May, 1972, do. 414, 416.

CxJ

X CO

E-i Cu

< CO

s a

CO
Ed

o x

Although the commissions on oDtions transactions, as a proportion
of the amount of money involved in a transaction, are higher than
for stock, the dollar amount of commissions on an option contract for
1 call to buy 100 shares of stock is about one-third as large as the
commission on a 100 share transaction in the underlying stock. Because
most brokers have a minimum commission charge, however, a better
comparison might be 5 contracts for which the options commission
charges are roughly one-fourth the commission on a 500-share stock
transaction. 4/ Commissions, of course, would be different on options
and stock trades at different prices than those used in Figure 4,
but the dollar amount of commissions on an option will be less than
on a stock trade in an equivalent number of shares underlying the
option. Some discount brokers have advertised rates as low as $12.50
per option contract for fewer than five options, and $2.50 - $8.50
per contract for orders of five options or more; but such rates
may be set purposely low to attract customers with a large volume
of orders.

^/ Moreover, if the options expire worthless, the loss is automatic
and there is no sale commission involved, whereas a stock
commission is incurred on the sale of a stock at a loss or
profit.

Commissions ana commission equivalents (retail mark up) affect
uotn tne proritaoility ot a transaction and the incentives of broKer-
dealers and tneir reyistered representatives in recommending invest-
ments to tneir customers, as is described in more detail below in
cnapter V.

b. Options Pricing Models

as indicated above, tne options contract serves to unbundle the
risKs and potential rewards associated with short-term stock price
movements. Tne options price is the market valuation ot the oundle of
rigiits tnat are being transferred. Chief anong these is the right to
oenetit from or limit losses from short-term stock price fluctuations.
Tne perceived probability of significant stock price cnanges will
otten retlect tne past snort-term price movements of the stock.

borne stocKs trade witnin relatively narrow snort-term price ranges,
wnereas otner stocks are uore volatile. For example, the Wall Street
Journal reported on December 12, 1978, tnat for the 52 prior weeks
American Telephone and Telegrapn traded between 56-7/8 and 64-5/8 a
snare and closed on December 11, 1978 at 61 per snare. However,
Minnesota Mining and Manufacturing Company ("3M") nad traded during
tnis period between 43 ana 66 a share and closed on December 11, 1978,
at bl, It all otner factors could be held constant, the premium for
an option usually would be greater tor a stock whicn is expected to

nave volatile snore-term price movements than the premium tor an option
lor a stocK wnicn is expected to trade witnin a narrow range during 1
lite ol tne option, accordingly, tiie volatilities or AT&T and 3M may
nelp to explain why AT&T July 6U options closed on December 11, 197b,
at J- J/4 wnereas tne 3*4 Juiy bU options closed at 7-3/b. LiKewise, if all
otner lactors could be held constant, the price ot an option would decline
as tne contract approaches maturity. Thus, on December 11, 1978, the
Ji" Jan oU options closed at 3-J/b wnile tne 3il July bus closed at 7-3/b.
bimilarly , it all otner tactors could be held constant, the price ot an
option woulo increase or decrease as the price of the underlying stocK
riuctuates around tne option exercise price. The amount of the increase
or decrease, it any, would ot course depend upon the perceived probability
tuat tne stocK would trade at an advantageous price in relation to tne
exercise price at expiration. For example, it a call option had an exercise
^rice ot ^ju witn one weeK lert to expiration, a movement in the price
ot tne stocK trom 4U to 41 would probably have no effect on the price
ot tne option.

ut course, all lactors cannot be neld constant, and the prices
or options reflect tne complex interrelation of ail of the above
ractors as well as additional tactors tnat apply in a free market
wnicn reiiects tne judgments ot tne various participants. Neverthe-
less, many professional traders and arbitrageurs with low or no trans-
actions costs nave developed options pricing models based upon these basic

principles and upon other factors which they deemed relevant. This is
done in an attempt to identify options which appear to be under or over-
valued in relation to other options and to the stocks, in anticipation
that they will profit if these pricing discrepancies disappear and to
prevent paying prices that are too high or accepting prices that are too
low. Computers are normally used because of the multiplicity of relevant
factors, many of them generated by constantly changing conditions in the
securities markets.

The most widely known options pricing model is the theoretical valuation
formula developed by Fischer Black and Myron Scholes from which most current
options pricing models have been derived. The Black-Scholes formula was
developed from the principle that options can be used to eliminate market
risk from a stock portfolio. This theory assumes that efficient option
pricing would result in returns on options portfolios equal to the risk-
free interest rate available on investments in U.S. government securities.
Their pricing model was developed using European options which are exercisable
only at maturity and has been revised, in part, because it assumed factors
which are not characteristic of listed options, including (1) no transactions
costs; (2) no dividends; (3) the option would be exercised on only the
final day before its expiration; (4) there were no restrictions on short
selling; and (5) various assumptions about the characteristics of stock

price movements . 5/ Nonetheless tne Black-Scholes options pricing model
serves to illustrate now options pricing models work..

Tne blacx-bcnoies mathematical options pricing model requires five
items ol information to compute an estimate of an option's theoretical
value at any point in time: (1) stock price; (2) time to maturity;
(j) exercise price; (4) risK free interest rate; and (5) probable volatility
or tne stocK. 6/ All tnese factors, except volatility, are readily
aetenitinaoie as of a particular point in time. In most computer pricing
moaeis tne luture volatility of tne stocK is estimated based on its past
volatility.

Tne blacK-bcholes or similar options pricing models are also used
to estimate tne dollar-tor-dollar sensitivity of an option's price to
movements or tne price in the underlying security at any point in time.
Pricing models noid constant tne factors other than stock price that affect
tne value of an option while estimating the relationship of changes in
tne price or tiie option relative to changes in the price of the stock.
Tnis estimate of the ratio relationship between the dollar change in the
^rice ol tne option and tne dollar change in tne price of the stock is
called the "delta r actor." Tne delta factor of a call option can range

V lilacK, Fischer and Scnoles, Myron, "The Pricing of Options
and Corporate Liaoilities" The Journal of Political
Economy , nay/June 1973, p. 640.

_b/ rilacK, Fischer, "Fact and Fantasy In tne Use of Options,"
Financial analyst Journal, July-August, 1975, p. 36.

40-940 ■

from 0 to plus 1.00. The delta factor of a put option ranges from 0 to
minus 1.00. If for every one point rise in the price of the equity
security the call option price rises 1/4 point, the call option has a
delta of .25 (and the put option a delta of -.75). If, for every point
rise in the stock the call option price rises 1/2, the call option has
a delta of .50 (and the put option a delta of -.50). JJ

A long call position and a short put position increase and decrease
in value with the stock. Therefore, these positions have positive delta
factors. The value of a short call position and long put position moves
in the opposite direction of the stock price. Therefore, these posi-
tions have negative delta factors, h long stock position has a delta value
of 1.00 while a short stock position has a negative delta value of 1.00.

By assigning a delta value to all stock and option positions, a
specialist /mar ketmaker on the floor of an options exchange can establish
long and short positions in various series of options of the same class
and in the underlying stock which, if his estimates of the various delta
factors are correct, can result in a position in which any increase or
decrease in value of the stock will be offset by increases or decreases
in his combined options and stock positions. If his calculations are
correct, and his positive deltas are equal to his negative deltas, his
overall oosition will be free of risk of stock price movements and his

]_/ See Black, F. and M. Scholes, "The Pricing of Options and Corporate
Liabilities, Journal of Political Economy (May/ June, 1973), po.
642ff.

portfolio is said to be in a "neutral delta position." For example, a
sale of a call option, which has a delta of .5, can be hedged by a purchase
of two call options having a delta of .25. In this case, the value of the
short option's position will decrease by $.50 for each $1 increase in
the price of the underlying stock and the two long options will increase
by $.25 each, or a total of $.50, offsetting the loss on the short option
position.

The delta factor changes as the price of the underlying security
and the other factors that determine the price of the option change.
Usually the changes will be small on a day-to-day basis. The exception
occurs during large stock price movements when, apparently, the
statistical reliability of estimates of delta becomes suspect. How-
ever, through the use of options as hedges, portfolio managers have
sought to reduce or eliminate virtually all of the market risk on their
portfolios. However, as the market risk is reduced, the theoretical
rate of return is also reduced until it approaches the risk free interest
rate, a return which can be approximated by investing directly in U.S.
government securities.

While the computer option pricing models illuminate certain of the
factors affecting the pricing of options and can aid in options trading
decisions, the chapter on Sales Practices shows how computer -gene rated
data and certain mathematical relationships have formed the background
for unethical sales practices by broker-dealers and investment advisers
and have been used to add mysticism and unnecessary complexity to options
transactions.

7. Examples of the Effect of Options Contracts
Assuming tnat there are no pricing biases or market inefficiencies
wnicn are disadvantageous to either options writers or buyers, 8/ then the
value of the bundle of risks and potential rewards being transferred under
an options contract should be approximately equal except for commissions
and other transactions costs. An example of how an options buyer and options
seller may tare during tne lite of a seven-month options contract can help
deiiDnstrate the effect of the options contract on both buyer and seller
during a period of short term price movements in a hypothetical situation,
assuming that both the buyer and seller hold the contract until expiration.
as indicated auove, nowever, nearly all options market participants close
out tneir options positions in the secondary market prior to expiration.

b/ Tnis assumption is useful for exposition purposes, but studies indi-
cate that in tne real world, pricing inefficiencies and biases do
exist, tor example, in a study of OTC options, BlacK and Scholes
round that through pricing biases wnicn favored the seller, buyers
ettectively paid all of the transactions costs necessary for mainten-
ance of tne marKet. See BlacK and Scholes, note 3, p. 12 above,
at pp. 413-417.

also, studies by Gould and Galai, and Klemkosky and Resnick suggest
tnat theoretical put and call parity is violated by systematic
divergence of put and call prices in the real world. Listed options
have reduced these divergences and usually transactions costs in and
out preclude profitable arbitrage by most public investors. While
listed options have reduced transactions costs, there is no reason
to assuiiie that bias no longer exists, especially with restrictions
on listed puts and the higher costs that are thereby imposed on
arbitrage activities. See Gould, J. P. and Galai, D. , "Transactions
Costs and Put and Call Prices," Journal of Financial Economics, (July
1974), Galai, Dan, "Tests ot Market Efficiency of the Chicago Board
Options Exchange," Journal of Business, (April 1977) and Klemkosky,
Kooert C. and Resnick, Bruce G., "Put-Call Parity and Market Efficiency"
presented to Southern Finance Association Annual Conference, November
1978, Washington, U.C.

a . Call Option

Assume, for examole , that XYZ stock is selling at $50 a share on
October 20, and that a call option on XYZ expiring in May and exercisable
at 50 trades at 6. The writer of this option will receive $600 per contract
paid by the buyer before any allowance for transaction costs. Of course,
both sides in this transaction would have to pay commissions. If the writer
owns the 100 shares of XYZ (a covered option), he will be in a better
position than he would have been without the combined stock/option position
anytime the stock trades at less than 56 but above 44 per share, after
allowance for transaction costs (see Figure 5). The writer of the call
option, however, may be called upon to deliver the shares anytime, although
exercise is likely only when the stock price is above $50. If the writer
of the option does not own the underlying stock (an nncovered option)
or an offsetting option, the writer assumes the risks of rises in the
market price of the underlying stock and will be required to acquire and
deliver the underlying stock, much like a short-seller, if the option
is exercised against him. In exchange for the options premium, however,
the writer of the option gives up to the option buyer the right to gains
through exercise or resale of the contract. This would normally only occur
if XYZ sells above $50 a share. The covered writer retains the risks of
ownership if XYZ declines in Drice. The uncovered writer is exposed to
unlimited risks on the upside, but none on the downside.

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The buyer of this same call option will be ahead if the price of
XYZ _rises above 56 per share sufficiently to cover the costs of exercise,
his premium and transaction costs (exercise price $50, plus premium $6
plus transaction costs). The call option buyer's total outlay and
potential loss is limited to the premium plus commissions, whereas his
outlay, for 100 shares of stock, would have been $5,000, plus commissions
and he would bear the full risk of a market decline. If the stock price
does not change from $50 Der share, however, the call option buyer's
option would exoire worthless and his whole investment would be lost.
A stock investor, on the other hand, is not likely to lose all of
his investment because of the high quality stocks underlying options
and his ability to sell the stock at any time.

Because of the secondary market, either the buyer or the seller or
both can close out the ootion position at any point until expiration by
resale or reDurchase at whatever the value of the option appears to be
at that time. Thus, loss of premium can be reduced or profits realized
through closing transactions in the secondary market.

b. Put Option

The writer of a put is obligated to buy stock, at any time during
the life of the put, at the exercise price, upon delivery by the put holder
of the underlying shares. For the writer of an XYZ May 50 put to protect
himself from assuming the risk of a drop in the stock's price, he could
sell XYZ shares short, say at $50 a share. A premium of $500, received
by the out writer who has an equivalent short position in the stock, would
place him ahead if the price of XYZ rises no higher than $55 per share

100

(less transactions costs) or declines to no less than $45 per share (plus
transactions costs during the life of the option (see Figure 6). If XYZ
sells below 50 per share, the put writer may be called upon to buy XYZ
stock at 50 per share. If that happens, he will lose the benefit of part
or all of the premium depending upon how far the market is below $50 per
share. The put buyer will continue to recover portions of his premium
until the stock sells below 45 (plus an amount sufficient to pay trans-
action costs) at which point he would have recovered the premium from
the put purchase and entered his gross profit region. If the put buyer
also owns XYZ stock at the time of the purchase of the put option, he
has what is referred to as a "protective" put and he will assure himself
of a gross sale price of $50, net $45 ($50 less his premium) in the event
of a price decline. Again, of course, no allowance has been made for commis-
sion costs. By paying the premium, however, the put buyer would have
indicated his willingness to accept a net price of $45 a share and to
give up the benefits of small gains (i.e. , gains up to $5 plus trans-
action costs) for protection against a large loss ( i.e. , declines
exceeding $5 plus transaction costs) if the stock price declines.

The listed puts could be liquidated at any time in the secondary
trading market, recovering part or all of the premium value and
taking losses or profits.

101

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102

c . Gains or Losses to Options Buyers are Offset by
Losses or Gains to Options Sellers

The above diagrams show how the options buyer and seller each may
fare as the stock price moves up and down during the life of the option.
The manner in which any gain or loss realized by the options seller is
offset by an equivalent gain or loss for the options buyer (exclusive
of transactions costs) can be illustrated by simple diagrams showing the
areas of potential loss and profit of buyers and sellers of options con-
tracts in circumstances where the writer is uncovered (see Figures 7 and
8). These illustrations assume that there are no pricing biases or market
inefficiencies which are disadvantageous to buyers relative to sellers
and vice versa.

Option premiums reflect the risks being assumed by the writer or
alternatively the costs of reinsuring against those risks through
covering hedging transactions. They also reflect the option buyer's
perception of the value to him of the potential benefits from
expected price movements in the underlying stock as well as the
avoidance of the usual costs associated with taking positions in the
underlying security. Because of the general equivalence of the costs
of alternative positions in puts and calls and of the probabilities
associated with short-run upward and downward price movements in under-
lying securities, the risks in writing and the potential returns in buying
a call and a put tend to approximate each other. The interrelationship
between the stock, a put and a call, is such that there exists a

103

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105

process called conversion throuqh which a put can be converted into
a call and a call into a ojt . For example, the combination of
the purchase of the underlying security on margin olus the purchase
of a put is the functional equivalent of a long position in a call
ootion. Likewise, a short sale of stock and the purchase of a call
is the equivalent of a long position in a put option.

Recognizing the necessary interrelationships between put and
call prices, Hans Stoll developed a theory of put and call parity. 9/
According to this theory, and subsequent tests of it, an arbitrage
mechanism tends to keep put and call prices in line with each other
through riskless conversion activities. Stoll pointed out how a put
could be converted into a call (and/or a call converted into a put) at
no risk to the converter. The principle of put and call parity has
been used by other researchers to assess the pricing efficiency of
the ootions market.

_9/ Stoll, Hans R. , "The Relationship Between Put and Call Option
Prices," The Journal of Finance, December 1969. Merton later
concluded that the theorv was applicable only to a European
option, one not exercisable until maturity. See Merton, R. C,
"The RelationshiD Between Put and Call Option Prices: Comment,"
The Journal of Finance, 28 (March 1973) pp. 183-184.

106

B. PRINCIPAL STRATEGIES

1 . Introduction

Options participants can be grouped into three categories: 1) public
non-professional participants, 2) professional money managers, and
3) professional traders and arbitrageurs. The basic purposes served
these participants by the various common types of options transactions
are: to obtain leverage, to hedge positions in the underlying security,
to increase current income from securities holdings, to arbitrage for
profit, to speculate or trade on perceived over -and-under valued situa-
tions, and to facilitate the provision of brokerage and marketmaking
services in the underlying stocks.

Investors have varying user perspectives as they approach the options
market. Traders, for example, attempt to capitalize on undervalued and
overvalued situations by using complex mathematical models and computer
techniques to detect and arbitrage against perceived illogical divergences
in prices. Studies of option price oatterns, however, indicate that while
price divergences do occur which may provide profitable trading opportunities
for professionals the divergences generally are too small for trading
ooportunities by members of the public because of transaction costs.
Other, generally sophisticated, investors perceive an opportunity to adjust
the risk-reward mix of their portfolio of assets in a more precise manner
because of the additional combinations of risk and potential return
opened up to them by the availability of exchange traded options.

io:

Risk management and risk adjusted performance have become basic criteria
upon which professional managerial ability is evaluated. Most individual
investors in options, however, are probably using option purchases and
sales as a substitute for stock purchases and sales. Dealing in options
enables them to take short-term positions in the stock, or shift out of
the stock in the short-term with lower transactions costs; and, for buyers,
it offers greater leverage than would be the case if they were trading
directly in the underlying securities.

2. Ten Basic Strategies

Although there are a great many different options strategies, Harris
Associates, Inc., in its survey of options investors, 10/ listed ten common
strategies that appear to be commonly employed by investors:

Buying

1) Buying options in combination with stock ownership.

2) 3uying options in combination with fixed-income securities.

3) "Pure" buying of options without underlying stock or fixed-
income securities.

Mixed Strategies

4) Buying options against a short position in underlying
stock.

10/ A Survey of Investors In the Listed Cations Market, Louis Harris

Associates for the American Stock Exchange, Inc., May 1976, p. 112.
The source of data for this survey was interviews with a clustered
systematical probability sample of 319 options customers selected
from 5 of the 20 largest options retail firms. The firms were
selected on the basis of various subjective characteristics,
including willingness to cooperate.

108

3) tmying options as a hedge against a short position in
securities related to the underlying security.

6) Selling options hedged against otner related securities.

1) spreading options by buying and selling different options
in tne same underlying securities.

selling

8) selling rully covered options.

y) Selling partially covered options.

10) selling completely uncovered options.

The strategies that the Hams survey identified are as follows: 11/

i) "Pure" ouying of options witnout underlying
stock or rTxeo-income securities

'mis "strategy" is the most commonly employed by options buyers.

It entails a substantially nigher degree of risk than does the simple

investment in tne underlying stocK because relatively large increases

in tne price of tne underlying stocK are required if tne buyer is to

profit trail tnis activity. Wnile the leverage obtainable through the

purcnase of options holds fortn tne potential for large profits if

the relatively large increase in stock prices occurs, such large

increases are relatively infrequent and, tneoretically, are offset

by nore trequent, smaller losses. Moreover, attempts to roll-over

options positions, because of tne frequent payment of commissions

on sucn roll-over transactions, will generally eliminate the

possibility tnat investors on tne average will realize any long-term

11/ The Options study does not endorse or recommend any of the
stategies described at pp. 28-34. They are used only to
illustrate tne common strategies that tne Harris survey found.

!()<>

^rorit train tnis strategy. Tne simple ouying of options is a highly
etricient substitute tor snort-term trading in tne stock. Tne use of
options enaoies a snorx-tenr. traaer to avoid the substantially larger
oociinissions required ana to use less tunas than would be required to meet
tne purcnase of an equivalent position in tne stock. It may thus help
mm to ootain a mucn larger position in a stock with a limited amount
oi capital. It also exposes mm to a risK ot losing his entire investment.

2) selling fiuly covered options

Tnis strategy is a suostitute for the short-term sale of stock.
Anile r.ost investors who write fully coverea options appear to do so in the
nope ot increasing their returns from a given stockholding, the evidence
indicates tnat tney are merely transferring tne short-term risk of small
i.ovanents in tne price ot tne underlying security to tne option ouyer
in excnange tor giving up tne potential for large profits from the underlying
stocKholaing . ±2/ Tne net etfect is that ooth the risks and potential
rewaras or stocK ownersnip have oeen reauced. In effect, the fully
covered writer is engaging in a partial sale of his security position

12/ rterton points out that in quiet periods when little company-
Sj^ecitic information is arriving at tne market, writers will
tena to maKe wnat appear to De greater than normal profits and
outers will appear to lose. However, in tne relatively
mrrequent active periods, tne writers will suffer large losses,
or, lr covered, will forego large profits, and the buyers will
profit oecause movements in stock prices occasionally exhibit
large discontinuities or "jumps" in movement. The writer's large
losses occur just irequently enougn to, on the average, offset the
auaost steady excess return. Merton, Robert C. , "Options Pricing
wnen underlying btock Returns are Discontinuous," Journal of
Financial Economics (1976), p. 132.

40-940 O - 79 - 10

110

for the period covered by the option contract. If he wishes to maintain

a long-term position in the underlying security, but does not believe

that it will rise substantially during the period covered by the option

contract, then he can trade on this belief at significantly lower costs

by writing options than he could by temporarily transferring his stock

ownership. By writing an option, he is effectively taking himself out

of the market for that security until the price moves up or down by the

amount of the premium, except that he retains the right to any dividends

as long as he retains the stock and may retain certain tax advantages

that would be lost on the sale of the stock.

3) Buying options in combination with
present or potential stock ownership

The purchase of calls increases the leverage and risks of a

portfolio holding the underlying stock. Placing all of one's investment

in options, however, does entail substantially greater risks of loss than

either holding the underlying security or holding some portion of one's

funds in the underlying security along with the purchase of call options.

Call options may be purchased for the specific purpose of fixing the

future price of security purchases in circumstances in which an investor,

who currently does not have sufficient money to take the position in the

stock desired, anticipates additional funds in the future.

Ill

4) buying options in compination with fixed-
income securities

Tnis ^articular approacn to buying options is frequently used as

an illustration of a conservative use of options, in tnat tne risx. of

sucn a comoined invest_inent can oe significantly lower tnan investment

in tne underlying security alone. Wnetner it is more or less risKy depends

on tne proportion- of options in tne combined investment. In effect, tne

purcnase of options involves a nign degree of risK and tne purchase of

quality fixed- inca.ie securities a relatively lower degree of risk. There

are many possioie variations as one adjusts the proportion of the investment

tnat is in rixeo- income securities and alcernatively in options. While

talis strategy is frequently discussed in options articles and publications,

only a very small percentage of investors actually employs tnis technique. 13/

5) buying options against snort positon in
underlying stock

options can oe usee by traders to hedge a short position in the under-
lying stocx. or alternatively to neage against a decline in the underlying
stocx. because tne snort seller is exposed to very substantial losses
if ne is wrong (and tne stock price rises substantially), his potential
losses can oe limited oy the purcnase of call options. If he is right
(and tne stocK price declines suostantially) , the premium paid for the
calls is the cost of nis partial protection against large losses and offsets

13/ bee narris Keport pp. Iu7-i0b. Only 5 percent of the investors in
tnat survey used this strategy.

112

a portion of his gains. Similarly, an investor wishing to hedge against
a substantial loss in a stock held in a portfolio might purchase a put
option.

6) Spreading options: buying and selling different
options in the same underlying securities

Traders and arbitrageurs attempt, whenever possible, to buy under-
valued and sell overvalued options and to hedge positions taken in options
and in the underlying securities in a manner which capitalizes on perceived
undervalued and overvalued situations. The technique of spreading involves
the taking of positions in different options in the same underlying securities
on opposite sides of the market. Spread positions also may involve holding
an option with a different exoiration date from that of the option written,
holding and writing options with different exercise prices but with the
same expiration date, or holding and writing options with different
expiration dates and exercise prices. Because spreading activities require
the near simultaneous execution of buy and sell transactions and correct
judgment respecting the appropriateness of the relative prices of the
ODtions contracts used in the spread, a high degree of sophistication
and knowledge of options and option values is required in order to profit
from spreading activities as well as close attention to total transactions
costs.

7) Buying options as a hedge with respect
to related securities

Some stocks without options tend to move in relation to other stocks,

on which listed options are available. Options can be used to hedge positions

113

in tnese other related securities witnout listed options. Consequently,
options might oe used to necige a position in a security ot another company
in tne saiiie industry. In aadition options may oe used to hedge a position
in uonas convertible into tne stocK underlying an option.

B) belling options to nedge against other securities

Tne writing or options provides a hedge against smaller short-term
moves in tne price ot a related security. For example, a block: positioner
naving a long ^josition in a related stock or convertible bond that has
ueen purcnased trail a customer may wish to hedge his risK until he is
auie to sell the securities in tne market. He might write options and
erreccively snitt some ot nis short-term risK exposure in those securities
uo options buyers until nis position is sold at which time he can close
out nis options positions by repurchasing calls in tne market. Similarly,
ne mignt write puts against snort positions in the security.

9) belling partially covered options

Tne sale ot partially covered options involves tne writing of more
tiian one option contract for eacn hundred snares of the underlying security
neio in porttolio. The rationale for a partially uncovered position is
tnat tne change in tne price of tne option tnat usually occurs, for those
not oeep-in-tne-iioney s a result of a change in the underlying stock

14/ i\ call option, which is exercisaole tor substantially less than the
current marKet price of tne underlying stocx, is referred to as
being "deep-in-tne-noney, " and conversely for a put option.

114

is not on a dollar- tor-dollar basis. Therefore, an option writer may
believe that nis risk from price cnanyes in the option contracts he has
written is adequately hedged oy tne price change that occurs in the shares
or the underlying security being used as a cover. For example, contracts
tnat are out-or-tne-money lb/ may rise in price by an amount much less than
tne increase ot the stock. Tne risk of partially covered writing activities
is tnat tney depend upon tne use of a delta factor or hedge ratio which
cnanyes soaietiiies rapidly, so that to the extent tne option position is
uncovered tne exposure is tnat of a writer of an uncovered option.
lUj sex liny completely uncovered options

Tms activity involves the writing of options without a position
m the underlying stock. Tne risks are large, even larger than the pure
ouymg ot options. Tne writer of uncovered options can expect a profit
limited to the amount ot tne premiums received, but, like a short-seller,
ne nas theoretically unlimited potential liability if the market moves
against him* in tne case of a call, and a loss wnich is limited only by
tne exercise price in the case of a put.

3. Survey of Investor Use of Option Strategies
Tne Harris survey found that the buying of options in combination
witn rixed-income securities was the least used buying strategy among
individual options investors with only 5 percent using that approach.

lb/ A call option, which is exercisable at a price higher than the current
jfiarKet price of tiie underlying stocK, is referred to as being
"out-of-tne-money," and conversely for a put option.

115

uniy by percent 01 inoividua± options investors were even aware of that
strategy. 16/ Tne simple strategy of buying options alone (pure buying)
was, in lact, tne strategy used Dy b8 percent ot tne persons surveyed. 17/

aiiong individual investors, the Harris survey found that 74 percent
nad used some Kind ot pure ouying strategy, 61 percent had used some form
ot pure selling strategy, ana 18 percent had mixed strategies involving
both ouying ana selling activities. Among investors who utilized pure
selling strategies, 56 percent did so on a fully covered basis, 19 percent
on a partially covered oasis, and 19 percent on a completely uncovered basis.
Muong individuals investing a total of $2,500 or less in options, 49 percent
engaged in pure Duying witnout tne underlying stock or fixed-income secu-
rities, 21 percent in buying in combination with stocK ownership, and
41 percent nad engaged m selling fully covered options. 18/

in contrast to individual investors, 79 percent of the institutional
investors surveyed concentrated their activities on the selling of fully
covered options. Only 25 percent of institutions engaged in the pure
ouying or options witnout tne underlying stocK or fixed income securities;
and 12 percent purchased options in combination with stock ownership.
Only 7 percent of institutional investors purchased options in combina-
tion witn fixed- income securities. Many institutions are restricted to
more conservative covered writing activities by eitner legal or self-
imposed guidelines for investing. The Harris survey reported that 35

ib/ Harris report, pp. 107-108.
17/ Harris report, p. 108.
16/ Harris report, pp. lObft.

116

percent ot responding institutions were restricted to covered writing,
ana b6 percent ot tnose institutions witn $1 million or more in assets
were so restricted. 19/

Anotner survey ot individual options investors undertaken by the
i-ianayeiitent Analysis Center, Cambridge, Massachusetts and sponsored by
tne CBOc found tnat the strategies followed by options investors were:
mostly Duying (28 percent), mostly spreading (6 percent), mostly selling
uncovered (4 percent), and mostly selling covered (62 percent). 20/ While
tnis latter study cutters witn respect to tne specific questions that
were asxed ot investors, it found, as did tne Harris survey, that the
two strategies most frequently followed Dy investors were the simple
ouying ana covered writing of options contracts. The percentages cannot
ue uirectly compared because, among other things, the AMEX sponsored survey
asKea investors wnether they haa usea particular strategies while the
CtsGE sponsorea survey asked investors which strategy tney most frequently
rolloweu. Neitner survey included interviews with broker-dealers, a
professional, out extremely important group, using options in their
activities. blocK-positioning firms, marketmakers and otner broker-
aealers maKe extensive use or options in providing dealer services to
the public market, as is described Delow in the Trading Practices
cnapter.

19/ Harris report, pp. 109ff.
20/ KoDbins, et al p. 74.

117

As the aoove indicates, an options strategy can be used for a
stocK strategy and stocK and options can oe use in combination to
acnieve alternative investment strategies. Exhibit I (attached)
sets out a detailed list of now various stock and options strategies
can ue used as a suostitute for other stock, and options strategies.

4. Writing Options tor Premiums

wmle all of tne above strategies are used by investors, options
advertising oy broker-dealers and sales presentations by registered
representatives often empnasize the writing of covered options to obtain
cranium income and as a means to reduce tne risK of adverse market price
uovements, as is discussed more fully in the cnapter on Sales Practices.

Tne effects of altering tne risk- return ratio through options, however,
generally is not empnasized by broker-oealers and their registered repre-
sentatives or by published materials currently available to the general
jjuolic. ror example, the following excerpt from a handbook on options
states:

arter you reao tnis dook, you will never be satisfied
with less tnan 4U percent return, compounded annually.
Tne more you Know about tne stock market, the more
you realize that options writing is tne only way to
invest. 21/

une west Coast brokerage firm's radio advertisement conveyed a similarly

zl/ auster, Roil, Options Writing and Hedging Strategies, Hicksville,
New YorK, i975, p. 3.

118

optimistic view of options writing :

For a substantial number of investors, selling Call
Options is producing premium income in the neighborhood
of 12% to 20% on many good stocks. That's in addition
to tne stocxs' regular dividends. Of course, like
any investment, there are risks to consider as well
as opportunities.

Tnese statements focus on the premiums that at times are available

on tne sale of options and seem to imply that the overall rate of return

on a securities portfolio can be increased by tne sale of options. They

ignore tne effects on overall return that result from reducing risks when

stocxs and options are efficiently priced. It can be shown that portfolios

including options can be constructed which incorporate less risk and lower

potential return than an investment in the underlying stock. In an article

appearing in tne Journal of Business, Merton, Scholes and Giadstein reported

on tne simulated return on a fully covered writing program for a portfolio

ot 1J6 stocKs on whicn listed options were available as of December 1975

over a 12-1/2 year period from July 1, 1963 to December 31, 1975. 22/ Options

prices were simulated using a derivation of the Black Scholes options

pricing model although they also included dividends. Merton, Scholes and

Glacistem concluded that investors can reduce the risk exposure for a

portfolio of stocks through writing options but that, over a period of

time, writing options on a portfolio will reduce the expected rate of

return. Tney also concluded that the premium on covered call writing

22/ werton, Rooert C. , Scholes, Myron S. , and Giadstein, Mathew L. ,

"The Returns and Risk of Alternative Call Option Portfolio Invest-
ment strategies, " Tne Journal of Business, April 1978, p. 189.

119

should not be considered extra income to be added to the usual return

on a stock investment as some brokerage firm advertisements have implied. 23/

Merton, Scholes and Gladstein summarized the results of their study

as follows:

Because the levels of both option premiums
and expected returns will vary depending on
the perceived levels of volatility for the
underlying stocks and interest rates, an
unconditional estimate for the expected
return on a fully covered strategy is
difficult to make. However, based on the
simulations, an expected semiannual return
of between 3% and 4% appears to be a
reasonable estimate for an at-the-money
fully covered strategy when the expected
returns on the underlying stocks are
between 5% and 6%. The fully covered
strategy will frequently produce realized
returns somewhat higher than the expected
level. But because of the negative skewness
of the returns, these higher returns will be
counter balanced by the relatively infrequent
but substantially lower returns that will
be realized if the underlying stocks decline
sharply. 24/

While the Merton, Scholes and Gladstein study concluded that a consistent

practice of writing covered options would most probably reduce the overall

rate of return on the covered call writer's stock portfolio, it also concluded

that the covered call writer could reduce the volatility of the rate of

return. Based on their simulated 136 stock sample, the study concluded

that a consistent practice of writing covered calls would have reduced

the standard deviation of the portfolio returns by approximately 70 percent

23/ Merton et al, pp. 213-214.
24/ Ibid., pp. 213-214.

120

it m-tiie-uoney options were sold, by aoout 5b percent if at-the-money
options were sold, 25/ ana by 35 percent if the out-of-the-^noney options
were sold. 26/

altnougn tne rterton, Scholes and Glads te in study relied upon simula-
tion, tneir results correspond with economic theory that there is a basic
correlation in the long run between risk and reward. While their study
would seem to imply tnat tne purchase of options in combination with fixed-
income securities would have been beneficial over this 12-1/2 year period,
tnis period was cnaracterized by the largest bull market and the most
severe oear marKet since 192y-iy32. Unfortunately, comparable simulations
were not undertaKen tor "pure buying" strategies, tne one most commonly
used by buyers. However, the Merton, Scholes and Gladstein study demonstrates
tne need tor broKers and dealers to have studies to back up any claims
to customers concerning potential returns on options, as is recommended
in tne cnapter on Sales Practices.

2b/ wnen an option's exercise price is tne same as the price of its
underlying stocK, the option is said to be at-tne-money.

_26/ Ibid. , pp. 2uy-21u.

121

EXHIBIT 1

The Relationship Between Puts, Calls,
Straddles and Stocks

The relationship between puts, calls, straddles and stocks
is summarized below in terms of the risk and rewards resulting
from stock price movements during the life of the option to illustrate
the relationship between stocks and options positions. A stock position
whether held alone or in combination with options does not have
a limited life as does the option. The purchaser or holder of a put,
call or stock is referred to as being long, and the seller of stock
which is not owned, or the seller of a put or call is referred to as being
short. In summarizing the relationship below, each reference to stock
long or short is to 100 shares of stock. It is assumed that the
exercise price and expiration dates are the same for any combination
of either puts or calls or both and that the purchase price of a long
stock position or sales price of a short stock position is the same
as the exercise price of the options. It is also assumed that the
premiums received on the sale of a put or call would be the same as
the premiums paid on the purchase of a put or call, although this would
rarely be the case. In addition, the following summary does not cover
the different amounts of capital and margin that must be used to
establish the different positions or the effect of commissions
and dividends. In most instances, combining options and stocks

122

positions in the strategies listed below would be more costly
than the equivalent single stock or option strategy with respect
to which it is equal.

Long Stock = long call and short put. Buying a call and selling a put
with the same exercise price has the same market risk reward during
the life of the option as owning stock because the long call provides
the right to a benefit from an increase in the stock price and the
short put results in having the risk of ownership in the event of
a stock price decline.

Short Stock = long put and short call. Either of these positions
benefits from a stock price decline but provides no protection against
loss in the event of a stock price increase.

Long Call = long stock and long put. A long call provides the right
to benefit from an increase in the stock price but a premium has been
paid to limit loss. Similarly, buying a put to protect a long stock
position involves paying a premium to limit loss.

Long Put = long call and short stock. The short stock position will
benefit if the stock price declines, but the loss in the event of a
stock price increase is limited to the premium paid for the option.

Short Call = short stock and short put. The maximum profit on either
position is limited to the premium on the sale of the option (except

123

broker-dealers may also earn interest on the proceeds of the short
stock position). Neither oosition provides protection aqainst loss
in the event of a stock Drice increase.

Short Put = long stock and a short call. The maximum profit on

either position is limited to the premium on the sale of the option

and the holder of either Dosition retains the risk of ownership
in the event of a stock price decline.

Straddle; A straddle is a combination of positions. A long straddle
will become profitable if the underlying stock trades outside a pre-
determined range (generally measured by the premium and transactions
costs if the exercise prices of the options are the same) and a short
straddle will become profitable if the underlying security trades
within a predetermined range measured by the net premium received.

Long straddles can be created in different ways. A long straddle
can be constructed combining (1) long put and a long call or (2) short
stock and 2 long calls or (3) long stock and 2 long outs. (Note: A
lona Dut is equal to short stock and a long call. Thus short stock
plus 2 long calls equals a long put and long call. Similarly, a long
call equals long stock and a long put. Thus long stock plus 2 long
puts equals a long call and a long out . )

124

Short straddles can also be created in different ways. A short
straddle can be constructed by combining (1) a short put and a short call
or (2) long stock and 2 short calls or (3) short stock and 2 short puts.
(Note: A short put is equal to long stock and a short call. Thus long
stock and 2 short calls equals a short put and a short call. Similarly,
a short call is eoual to short stock plus a short put. Thus short stock
and 2 short puts equal a short call and a short put.)

CHAPTER III
THE USE OF OFriONS BY PROFESSIONAL TRADERS

INTKUJJUCriU^

wnen listed options trading began in 1973, a new range of trad-
my strategies, utilizing both stocks and options, became commonly
availaole to persons who wished to purchase or sell exchange traded
securities, rtany market participants, including retail customers,
institutions and professional traders, began using options along
with stocKs to try to improve their investment performance, or to
heuge their investments against market price movements. Unfortunately,
along^with tne new trading opportunities offered by options, came
new opj-ortunities tor abuse. In instituting the Options Study in
October 1977, tne Commission noted that certain abuses had occurred
in tne trading ot listed options (alone or in conjunction with trading
in underlying stocKs) and expressed concern whether the self-regulatory
organizations' surveillance and compliance systems could detect
ana prevent these anuses. 1/

as part of its task, theretore, the Options Study undertook
a review ot options trading practices used by certain professional
traders, wore than 10U persons actively involved in, or affected
by, listed options trading were interviewed, including market pro-
ressionals and the statf members of the self -regulatory organizations
responsible for the oversight of options trading practices. Options

1/ Securities Excnange Act Release No. 14056 (October 17, 1977)
( "October Release" ) .

(125)

40-940 O - 79 - 11

126

Study staff members visited the floor of each options exchange
and the options trading desks of several broker-dealers. Trading
records were obtained from selected broker-dealers, options specialists,
and marketmakers in order to document the details of activities
discussed during the interviews and observed during trading. In
addition, the Options Study reviewed sworn testimony and exhibits
from numerous options trading investigations conducted by self-
regulatory organizations and by the Commission's staff. The Options
Study, however, did not conduct independent investigations of
particular trading situations. Nor was the Options Study able to
review and analyze trading data or investigations that the self-
regulatory organizations initiated in sufficient detail to form
the basis for regulatory recommendations. As a result, further
study will be required to determine whether specific trading patterns
can be identified which should be the subjects of Droscriptive
rules and to formulate appropriate rules where necessary. 2/

In reviewing options trading practices, the Options Study fo-
cused primarily on the activities of "market professionals," —
that is, persons or entities:

(1) who trade on the floors of the exchanges, such as

marketmakers (CBOE) (MSE) (PSE); options specialists
and registered options traders (AMEX) (PHLX); and stock

2/ See p. 58, infra.

127

specialists and registered traders (NYSE); (collectively
referred to as "marketmakers" ) , or

(2) who are exchange members and initiate orders for their
own account from their offices ('uostairs firms"); or

(3) who effect a large volume of securities transactions
as customers of exchange members (,: institutions"
including so-called "hedge funds").

Accordingly, the chapter is a survey of the manner in which market
Drofessionals use options in the course of their activities and
should not be considered a complete description or analysis of the
manner in which all market participants use, or might use, options.
In addition, the chapter summarizes various trading practices identified
in the October Release and which may have involved violations of the
Securities Exchanqe Act and Commission rules adoDted thereunder, as
well as rules of the self-regulatory organizations.

All market professionals have two privileges which distinguish
them from, and give them advantages over, other market participants.
First, they have quicker access to exchange trading facilities -
because as members they are permitted to trade on the floor of an
exchange or otherwise have preferred access to the floor of an ex-
change through telecommunication systems or messengers. This access
to the trading floors enables market professionals to respond quickly
to information likely to affect the price of a security, such as un-
usual supply or demand for a security, wire service news about a par-
ticular issue, or general economic news. Second, market professionals

128

generally ao not incur transaction costs (e.g. , commissions) or trade
in sucn volume that the costs they incur are significantly reduced.
Mduitional advantages, such as favoraole margin treatment or access
to customers' margin securities, are available to some, but not all,
marKet proiessionals.

Tnese advantages allow market professionals to engage in certain
options trading strategies - such as arbitrage - which are not feasible
lor retail customers. Tne advantages also present market professionals
witn greater opportunities to engage in trading practices which violate
the securities laws than are afforded other market participants.

wnile uiarket proiessionals, as a general rule, use their
advantages to maximize their own trading profits, they also perform
userul t unctions in tne market place. Their most significant con-
tribution to the market occurs when their participation makes the
pricing of securities more efficient, and makes the markets for
both stocK and options more liquid. By making these contributions,
tne trading of market proiessionals helps assure that the prices
pUDlic customers pay for securities are fair and that these prices
quicKly reflect the host current and relevant information available
aoout the securities. In addition, marketmakers assume certain
obligations to the marketplace which upstairs firms and institutions
do not.

Tne sections below will first describe the functions and
legitimate trading activities of market professionals. Next,
questionable options trading practices will be examined. Finally,

129

certain trading rules will be discussed which are of particular
relevance to options trading by market professionals.
1. ON FLOOR MARKET PARTICIPATE
a. Obligations

Market professionals who trade on the floors of options ex-
changes ( "marketmakers" ) either trade for their own accounts,
act as agents for others, or, in some cases, do both. In 1977,
1,153 registered broker-dealers reported options marketmaking
activities on national securities exchanges. Their combined gross
profit from these activities was $33.1 million, although almost
40 percent (413) of the dealers reported losses, which in the
aggregate amounted to $15.9 million.

There are two basic marketmaking systems used by options
exchanges. The options specialist system of the AMEX and PHLX,
(similar to the system used on most stock exchanges), uses an
options specialist, who is assigned an options class or classes
for which he is obligated to make a market. The specialist is
permitted to act both as broker (agent) and dealer (principal)
in the options classes to which he is assigned. As broker, he
holds and executes orders for other members; as dealer he trades
as principal for his own account. The specialist system also relies
upon registered options traders ("ROTs") to act as dealers and to
perform a marketmaking function. A ROT is not assigned to or re-

130

quired to limit his trading to a single location or "trading post"
and he performs a marketmaking role when trading for his own
account. 3/ Unlike a specialist, however, a ROT may not act
as both a broker and as a dealer in the same options class during
the same day.

The other options exchange system for making markets, used by
the CBOE, MSE, and PSE, is the competing marketmaker system. This
system, as its name suggests, uses marketmakers to compete with
each other to make markets in the various options classes traded
on the exchange. The competing marketmaker system is characterized
by a separation of the broker and dealer functions. The broker (agency)
function for each options class is assigned to a "board broker"
on the CBOE 4/ and to an "order book official" on the MSE and PSE.
The marketmakers perform the dealer function, although they may also,
under certain circumstances, act as brokers. Unlike options specialists,
the marketmakers may trade at any post on the exchange floor. Under
the rules of the exchanges, marketmakers may not act as dealers and
as brokers in the same options class on the same day. 5/

3/ See, e.g. , AMEX rule 958. In practice, a ROT's marketmaking
obligation has not been extended beyond the requirement to
purchase or sell one options contract.

4/ The Commission recently approved a rule proposal of the CBOE to
abolish its current board broker system and replace its board
brokers with order book officials who would be salaried employees
of the CBOE. See, Securities Exchange Act Release No. 15490
(January 11, 1979).

5/ See, e.g., CBOE rule 8.8.

131

Under Commission and options exchange rules, specialists, ROTs
and competing marketmakers have an obligation to trade for their
own accounts so as to maintain a fair and orderly market (referred
to as their "affirmative obligation") and not to engage in trading
which is inconsistent with this obligation (referred to as their
"negative obligation"). 6/ This generally includes an obligation to
engage in dealings for their own account in order to maintain price
continuity and to minimize effects of a temporary disparity between
supply and demand, immediate or reasonably anticipated. 1/

Exchanges using both the specialist and the competing marketmaker
systems permit members called "floor brokers" to execute agency trades
on the exchange floors. Many floor brokers are employees of member firms

6/ See, e.g., 17 CFR 240.11D-1, CBOE rule 8.7.

7/ The Options Study did not evaluate the performance of options
specialists or marketmakers in meeting their affirmative and
negative obligations under the Exchange Act or options exchange
rules. Inasmuch as many significant regulatory decisions (such
as the availability of favorable margin treatment and the ability
to effect transactions on an exchange for one's own account) are
predicated upon these obligations, the Options Study believes
that a thorough review should be undertaken to define these
obligations more precisely and to determine whether options
specialists and marketmakers are meeting these obligations.

132

who primarily or exclusively execute orders for their firms' proprietary
trauma accounts and tor public customers of the firm. Other floor
oroxers, sane times called "two dollar brokers", are self-employed and
execute oraers on behalf of marketmaKers and member firms which
either do not enploy tneir own floor brokers or which, on occasion,
need to supplement tneir existing personnel. Floor brokers, unlike
specialists, kOTs and marketmakers , have no marketmaking responsibilities.

b. Privileges

In exchange for their marketmaking obligations, marketmakers
enjoy certain advantages. First, they have access to information
regarding the market wnich is unavailable to persons not physically
present on the tloor. They may, for example, be able to gauge the
supply ana demand ror a particular security by observing the flow
ot orders at that security's trading post. On the CBOE, MSE and PSE,
traders can also obtain information concerning prospective transactions
Dy ooserving, on a television-like screen at each trading post, the
uest puolic bia and asked quotations tor an options series that the
limit order book contains, b/ More subtle pieces of information
are also available to marketrivakers . Because of their familiarity

b/ On the AMEX and PHLX, however, the options specialist is generally
tne only person wno is aware of the limit orders which he holds
in nis "book. " AMEX has recently begun to experiment with the
leasiDiiity ot exposing portions of its options specialists'
books to other market participants.

133

with tloor personnel, tne traders may recognize a certain floor broker
who is Known to represent certain large institutional customers, and
may thereby anticipate, as lie moves into the trading crowd, a large
order wnicn may be ellected in one or several transactions. They may
also ue aDle to identity and interpret tne significance of specific
trading tecnniques employed by a particular floor broker or marketmaker.
Pernaps most significantly, the marKetmaker can know of, and react
to, changing quotations and executed transactions as soon as they
occur, most oil-floor market participants do not have access to this
"iloor- related" information until it is publicly disseminated; as a
result, this information is useful only to those on the exchange
tloor.

Second, options marketmakers receive special margin treatment for
tneir options and stock transactions to permit them to provide liquidity
wnen necessary. 9/ Their options transactions are not subject to any
margin restrictions out are subject to financial responsibility require-
ments. 1U/ With respect to their stock transactions, options market-
maxers are given relaxed margin treatment. 11/ For example, if an options

9/ bee Cnapter VII.

10/ Id.

11/ I'larketmaxers and other traders affecting transactions as dealers
on the excnange tloor are designated Dy the options exchanges as
"specialists" lor purposes of the Exchange Act. See, e.g. , CBOE
ruie b.l. This designation permits these traders to receive the
lavoraoie treatment accorded all specialists under Federal Reserve
board margin regulations, adopted under Section 7 of the Exchange Act,

134

marketmaker hedges his options positions with stock, and then liquidates
the stock position within five days, he, unlike a public cus toner,
is not required to make any margin deposit with his clearing firm.
This advantageous margin treatment has permitted options marketmakers
and specialists to assume and liquidate stock positions within five
days without meeting initial margin requirements. 12/ In addition,
like all exchange members, they do not generally pay commissions on
their options transactions. They are therefore able to trade frequently,
to profit from small price changes, and to assume securities positions
at lower costs than non-members.

Finally, like other professional traders, marketmakers often
have access to computers which use various pricing models to compute
theoretical values for options. 13/ This information helps traders
to identify trading opportunities, analyze alternative strategies,
and monitor their existing securities positions. Marketmakers
are able to study computerized pricing models in their offices (or
the offices of their clearing firms) both before the trading day
begins and at any time during the day, although they have to leave
the exchange floor to do so. The computerized pricing models also

12/ A description of this practice, and the Options Study's recom-
mendations on this subject, are contained in Chapter VTI.

13/ For a more complete discussion of the theoretical value of an
option and the use of delta analysis, see Chapter II.

135

provide information on tne "delta" ot an options series, which is a
mathematical relationsnip oetween underlying stock and options prices
oased on relatively small snort-term price movements in the underlying
stocK. 14/ Delta factors are used by traders to calculate the exposure
to marKet risK inherent in tneir options and stock positions, and to
adjust their positions to avoid unacceptable risk. 15/

c. Options t raging strategies

Tne nvarketmaKer uses his advantages in the marketplace to earn
trading prorits lor ms own account. In accomplishing this end, he may
employ a variety of trading strategies designed to maximize profits
and to enaoie mm to minimize or control the risks of his options
positions.

Aitnougn each marKetmaxer ' s method of trading is, to a certain
extent, unique, tnree general approacnes to options marketmaking are
cohuion. These are categorized as "scalping", "spreading" and
"position trading."

Tne term "scalping" describes a trading strategy in which a trader
tries to Duy options at tne bid price (e.g. , 1-1/2) and sell them
at the asKed price (e.g. , l-5/tt) in order to profit from the differ-

14/ Id.

lb/ ueita analysis is also used Dy some clearing firms as a measure
or tne risK exposure ot tne marketmakers tor wnom tney clear
transactions. For a description of the delta formula, and its
use as a risK measuring device by clearing firms, see Chapter VII.

136

ential, (in this case, 1/8 of a point). This trading strategy requires
a rapid turnover of positions, both to limit risk and to achieve mean-
ingful profits from the narrow spread between the bid and asked quotations.
The term "spreading" describes the simultaneous or nearly simultaneous
purchase and sale of two different options series of the same class
in order to reduce the risk associated with a simple long or short op-
tions position. Frequently, options perceived as relatively undervalued
are bought and those perceived as relatively overvalued are sold. This
assessment of each option's value is derived either from a computerized
pricing model or from the marketmaker ' s subjective analysis. "Neutral
spreaders" attempt to maintain offsetting options positions in
order to minimize the impact of price movements of the underlying
stock on their spread positions. Profit is earned as market forces
"correct" the relative valuations of the options. Position trading
refers to several trading strategies in which the marketmaker
acquires longer term options positions, generally by spreading
or call writing against long stock, which are based upon his opinion
of the anticipated future price movements of the underlying stock.
The fundamental elements of scalping, spreading and position
trading are summarized in Table 1.

137

TABLE 1

SCALPING

SPREADING

POSITION TRADING

Basic Strategy

Use of Options
Pricing Model

Buy/ sell all as-
signed classes at
bid/offer to earn
differential

Buy relatively
undervalued op-
tions; sell re-
latively over-
valued options.
Reduce risk
associated with
simple long or
short options
positions

Inherent part
of strategy

Speculation on
market movements

Occasionally

Opinion on
Underlying
Stock

Not necessarily

Inherent part
of strategy

Time Position
Held

As briefly as
possible - rarely
overnight - for
this reason
scalpers are
often called
"day traders"

Makes adjustments
and constantly
changes positions

Frequently until
expiration

Use of Stock

Occasionally
when options
cannot be used
or are not an
economical
hedge

Inherent part of
some strategies

Capital Needed

Vulnerability
to price
movement in
underlying
stock

Minimal

Relatively little
vulnerability be-
cause of rapid
turnover of
small positions

Moderate

Vulnerable to
large price
fluctuations
in underlying
security;
neutrally hedged
for small move-
ments

Substantial
Substantial

138

While individual marketmakers generally favor one approach
to trading, most remain flexible in responding to market conditions.
A scalper may become a spreader if he is unable to close out a posi-
tion at a reasonable price. A spreader may become a scalper by closing
out one side of a spread in response to an attractive bid or offer or
upon receipt of an exercise notice for the underlying stock. An options
marketmaker may begin the day with a planned approach and then be forced
to reevaluate his trading strategies in response to order flow, his
marketmaking obligations, or the price movement of the underlying
stock. N.

d. Stock/options trading strategies

The Commission has prohibited stock specialists and registered
stock marketmakers on the NYSE and AMEX from trading options in their
specialty stocks or stocks in which they hold positions 16/ because,
among other reasons, of the potential for manipulative and other improper
activity inherent in such an arrangement. 17/ Marketmakers, specialists
and ROTs on the options exchanges, however, have been permitted to trade
the equity securities underlying the options in which they make markets.

16/ In 1977, the Commission determined to permit specialists and
odd-lot dealers on the floors of the regional stock exchanges
to trade listed options on their specialty stocks and to allow
marketmakers on those exchanges to trade listed options with
respect to underlying securities in which they held a position
because "the manipulative potential inherent in [permitting such
trading] appears relatively insignificant." See, e.g. , Securities
Exchange Act Release No. 13269 (February 16, 1977), No. 13270
(February 16, 1977), and No. 13272 (February 16, 1977).

17/ See discussion at Chapter VII.

139

Several economic factors, however, would seem to discourage the
use of stock by options marketmakers in devising strategies. First,
when an options marketmaker wishes to buy or sell stock, the transaction
must be effected through a stock exchange member firm who charges
the options marketmaker a commission for the service. 18/ While these
charges are generally lower for options marketmakers than for market
participants who are not exchange members, they are still higher
than the minimal clearing charges which these traders incur for
their options transactions. Second, if the options marketmaker
purchases the stock on credit - and he almost always does - the
amount of interest he must pay his creditor (usually his clearing
firm) is higher than interest he would pay for an equivalent options
position, since- the corresponding stock position will cost more
and the amount borrowed is obviously greater than for the equivalent
options position. Third, while an options marketmaker 's options trans-
actions are exempt from margin requirements, his equity positions,
used to hedge his options positions, are subject to a minimum 25 per-
cent margin requirement under Regulation T if not sold within five
business days after purchase. Fourth, a marketmaker 's stock sales
(but not purchases) are subject to the New York State transfer tax
if the sales are executed on the NYSE or AMEX, which are the primary
markets for all stocks underlying listed options. Fifth, the options

18/ If the options marketmaker is also a member of the stock exchange
where the transaction was executed, commission charges, with
the exception of floor brokerage, may not be incurred.

140

Hour trader nas immediate access to stock options quotation and trans-
action information but, because the stock transaction and quotation
information availaole on tne options exchange floor may be stale or
unreliaole, ne may nave to use personnel on the stock exchange floor
employed by nis clearing firm or tne firm through which he executes
stock transactions to obtain reports of stock quotations and transactions
ac a particular moment. This results in delay in the marketmaker ' s
receipt of pricing information and is a service for which the market-
maxer must ultimately pay, eitner directly or indirectly. Finally,
to place a stock oraer, a marketmaKer must leave the options trading
crowd (or at least momentarily divert his attention from options trading
activity), ana, as a result, may lose the opportunity to make an ad-
vantageous options traae.

Altnougn these economic considerations would seem to make stock
transactions sohiewnat unattractive tor options marketmakers , some
marKetmakers nonetheless appear to use stock extensively in their
trading strategies.

a marKetiiiaker may use stock to hedge an options position when
an options hedge mignt not be available. For example, if a trader
purcnased a large number of soon-to-expire call options in the only
near term m-tne-money 19/ series available for that options class, he

IV A call option is said to be "in-the-money" if the underlying
security's ^rice is greater than tne option's exercise price.
A put option is "in-the-money" if the underlying security's price
is lower than tne option's exercise price.

141

might be unable to hedge that position through the sale of options
in another series of that class (an "options hedge") because a very
large number of contracts would be necessary to offset the risk of
the initial options position. Such a large sale transaction might
be undesirable because of the market impact of buying or the
liquidity costs of selling the position. Moreover, if the options
hedge could only be accomplished through the writing of more than
1,000 contracts, the trader would be precluded from making such a
sale because of position limit rules which prevent him from holding
more than 1,000 options contracts on one side of the market. 20/

Options hedges are most likely to be unavailable in options classes
that are not actively traded or in which a limited number of series
exist. This may be more true if listed puts are not available for
a particular stock. In such instances, options traders may be more
likely to use hedging strategies involving the underlying stock.

In order to assess the extent to which marketmakers engage in
stock trading, the Options Study reviewed summaries of CBOE market-
maker activity in NYSE stocks underlying CBOE options. 21/ The review
covered six weeks of trading activity beginning in June 1978. This

20/ For a discussion of these position limit rules, see infra at
65-68.

21/ These summaries were prepared by the CBOE and did not cover

stock transactions by non-CBOE options marketmakers. Additionally,
the period under review included an expiration week and accordingly
may not be representative of the volume of stock transactions by
marketmakers at other times.

40-940 O - 79 - 12

142

review showed that stock trading by CBOE marketmakers as a group exceeded
15 percent of the reported stock volume in an average of four NYSE
listed stocks each day. On each day reviewed, CBOE marketmakers
purchased or sold more than 20 percent of the shares traded on
the NYSE in at least one issue. On occasion, the options marketmaker
activity exceeded 50 percent of the trading in a particular underlying
stock. In several instances, the marketmakers had no options position
in the stock in which they had been trading and thus the transactions
appear to have been unrelated to their mar ketma king obligations. 22/
As a general rule, options marketmakers who are well capitalized
tend to trade more shares of stock than traders with less capital because
they can afford the costs associated with maintaining a stock position
(including margin, if necessary), and because they can afford to assume
large options positions for which an options hedge may not be available.
The following tables, based on data analyzed by the Options Study, suggest
that well-capitalized marketmakers and specialists tend to have larger
stock positions relative to their options positions than those who are
less well-capitalized.

22/ These summaries indicate that stock transactions by CBOE market-
makers constituted a substantial amount of the transactions
in the underlying stock for the period under review. The
subject of stock transactions by options professionals, and
particularly the impact such transactions have on stock prices,
would appear to be an appropriate subject for further study
by the Division of Market Regulation. The relationship between
the stock trading by options marketmakers and the margin
regulations is discussed in Chapter VII.

143

Table 2

As of September 30, 1977

Account Equity ($)

Number of
Marketmakers

34 23/

Aggregate Long

and Short
Options Positions

Aggregate Long
and Short
Stock Positions

$ 194,575

Per a

Stock

to Opt

sntage of
Positions
ions Positions

less than 0

S 795,952

24%

0 - 4,999

272

2,728,885

275,861

10%

5,000 - 24,999

219

11,746,773

3,711,484

32%

25,000 - 99 999

197

31,313,658

0,325,927

33%

100,000 and over

141

92,928,614

2,110,035

77%

Table 3

As of December 30, 1977

Aggregate Long Aggregate Long Percentage of
Number of and Short and Short Stock Positions
Account Equity ($) Marketmakers Options Positions Stock Positions to Options Positions

less than 0

24/

$ 5,983,646

422,937

0 - 4,999

272

4,047,942

219,128

5,000 - 24,999

219

18,414,193

1,609,157

25.000 - 99 999

214

45,655,782

9,234,243

21%

100,000 and over

154

144,495,299

88,740,095

62%

23/ This does not include five MSE market makers who reported no stock
or options oositions.

24/ This does not include six MSE marketmakers who reported no stock
or options oositions.

144

2. UPSTAIRS FIRMS

Broker-dealers who initiate their proprietary trading off exchange
floors ("upstairs firms") principally use options to generate arbitrage
and trading profits. They can profit from such transactions primarily
because of certain advantages these firms enjoy over the public at large,
and even, in sane instances, over options marketmakers .

a. Advantages enjoyed by upstairs firms

The advantages enjoyed by upstairs firms in trading listed options
are similar in many respects to those enjoyed by marketmakers. Upstairs
traders can quickly obtain information from the trading floor (through
the floor brokers employed by their firms) concerning such matters
as order flow, executed transactions and changes in quotations. Like
marketmakers, upstairs firms have information systems which provide
immediate last sale and quotation information. Because traders at upstairs
firms have a direct "wire" i.e. , telephone line, to the floor, they
can react quickly to information by entering or canceling orders through
their floor brokers. In addition, because they are exchange members,
upstairs firms generally incur no commission costs on their transactions.
Finally, like marketmakers, upstairs firms use computer models as an
integral part of their trading, and most brokerage firms actively involved
in options trading have developed proprietary computer programs or modified
existing options pricing models to satisfy their particular needs or
to reflect their specific economic or trading theories.

145

In some respects, upstairs traders enjoy substantial advantages
over marketmakers. The last sale and quotation information available
to them is not limited to the relatively small number of options traded
at one post or the related underlying stocks. Display screens in their
trading rooms allow them to monitor transaction and quotation information
for all listed options and underlying securities. Moreover, upstairs
traders have immediate access to news developments and to input from
their firm's research department regarding fundamental and technical
factors.

In other respects, upstairs firms are at a disadvantage compared
to marketmakers. First, there is a timing disadvantage. The upstairs
firm's instructions must be transmitted to an agent or employee (the
floor broker) who must then try to execute or cancel the order in the
trading crowd. While this process may take only minutes (or less), in
an active market every delay may significantly alter the profitability
of a transaction. 25/

Second, because they carry customer accounts, the net capital re-
quirements imposed on uostairs firms by the Commission are substantially
different from those imposed on marketmakers by the clearing firms which

25/ The timing disadvantage is substantially reduced when the upstairs
firm gives its floor broker certain flexibility to "work" an order,
thereby reducing the need for the upstairs firm to transmit specific
instructions to the trading floor when market conditions change.

146

carry their accounts. This difference has affected the manner in which
upstairs firms trade options, at least to the extent of causing such
firms to forego certain proprietary options trading strategies if the
capital charges are unfavorable. For example, under the existing net
capital rule, certain well-hedged spread transactions (with predefined
risks) result in relatively high capital charges for upstairs traders
compared with the capital charges that would be imposed on marketmakers
with the same positions. Further, the essentially riskless nature of
certain arbitrage transactions is not fully recognized by existing net
capital rules. 26/

Unlike marketmakers, upstairs firms are not given preferred margin
treatment either for their stock or options transactions. Generally
they must meet the full margin requirements for any stock or options
positions they acquire. 27/

In a manner similar to other traders, upstairs firms engage in spreading
and covered and ratio writing strategies although, generally speaking,
such trading is not a function of their particular advantages. As is true

26/ Examples of the impact of the net capital rule on upstairs dealers
employing certain spreading and arbitrage transactions and the
Options Study's recommendations on this subject are contained in
Chapter VII.

27/ Exemptions from Federal Reserve Board margin requirements are

available for upstairs firms when they perform certain dealer func-
tions such as block positioning and third marketmaking, which are
deemed to be beneficial to the overall depth or liquidity of the
market. Dealers who effect transactions in listed securities as
principal off the exchange floor are called third marketmakers.
For a description of block positioners, see infra at 35-39.

147

of marketmakers , however, upstairs firms try to use their advantages
to make money for their proprietary accounts. As discussed below,-
upstairs firms are uniquely situated to employ two types of trading -
arbitrage and block trading - and listed options are often an integral
part of that trading.

b. Arbitrage" trading

Arbitrage transactions involve the simultaneous or nearly simul-
taneous purchase and sale of the same or equivalent securities at
different prices to take advantage of generally small price disparities.
These disparities may arise in the prices quoted for related securities
in different markets on which those securities are traded.

Arbitrageurs do not base their transactions on their opinion of the
underlying stock or the related options class. Since the pricing
inefficiencies are usually very small, only traders who pay little
or no transaction costs will find arbitrage opportunities attractive.
Moreover, these price differences frequently exist only briefly
before they are recognized by market professionals whose transactions
tend to eliminate these differences. 28/ Arbitrage profits can thus
be captured only by those persons who are able to recognize these
disparities, respond instantly, execute orders in different markets,
and are not subject to commission charges.

28/ Upstairs firms frequently utilize computers to monitor, on a real
time basis, last sale and quotation information for all option
stocks and options in order to identify arbitrage opportunities
in options and related underlying stocks.

148

An arbitrane transaction is subject to market risk if all components
of the transaction cannot be effected almost simultaneously, or if the
oarticular market is not sufficiently liquid to permit execution of
the comoonent oarts of the transaction before the price disparity vanishes
Once effected, however, many of these transactions allow the firm to
earn a nrofit without any market risk. 29/

Securities arbitrane adds to the overall liquidity and efficiency
of the marketplace bv introducing additional supply and demand and
bv narrowinq or eliminating pricing inefficiencies. The Commission
has stated that it views arbitraae as "performing a worthwhile
economic role since it seems to equalize the price of a different
security or its eouivalent when traded in different markets." 30/

Uostairs firms use listed options in connection with several
different proprietary arbitrage trading strategies.

(1) Conversion and reverse conversion arbitrage

Arbitrane technioues used by upstairs firms to take advantage
of pricinq inefficiencies between the premium of a call option and
the premium of a put option with an identical strike price and expira-
tion date ("corresponding put") are called conversions and reverse

29/ These so-called riskless arbitrage transactions should be compared
with risk arbitrane transactions, involving mergers or exchange
offers. See infra at 31-33.

30/ Securities Exchange Act Release No. 9950 (January 16, 1973)
(adoption of Rule 19b-2) .

149

conversions. Upstairs firms are almost alone in being able to effect
these strategies because they pay no commissions 31/ on stock or op-
tions transactions, and because they are ideally situated to monitor
the entire options and stock marketplace to identify conversion
and reverse conversion opportunities and to act upon them quickly.
Moreover, as will.be discussed below, in reverse conversion transactions,
access to stock at little or no cost to satisfy short sale delivery
obligations 32/ is a further significant advantage enjoyed by many
upstairs firms (particularly those firms with retail customers)
which cannot be duplicated by other market Drofessionals.

(a) Conversion arbitrage If a call option is overvalued
relative to its corresponding put, conversion arbitrage is used as a
riskless method of capturing the amount by which the premiums are
out of line. The conversion equation is as follows:

DONG STOCK + SHORT CALL + LONG PUT = NO MARKET RISK
If a firm establishes this position (short one call, long one cor-
resoonding put. long 100 shares of underlying stock) and holds the
position to the expiration of the options involved, the position presents
no market risk to the firm and at expiration, regardless of the direction
of movement in the price of the underlying stock, the entire position

31/ The term commission in this context does not include floor brokerage.

32/ When a seller effects a short sale he must deliver the stock
to the purchaser ' s broker within the time required for settle-
ment of the transaction, i.e. , five business days.

150

will be eliminated for the profit which existed when the position was
established. If the calls expire in-the-money, they will be exercised
by the holder and the stock will be delivered to that party; if the
puts expire in-the-money, they will be exercised by the firm which again
will result in the stock being delivered out of the firm. In either
case the out-of-the-money options will expire worthless and the long
stock will be delivered out of the firm pursuant to the exercise of
the in-the-money options.

Since holding the conversion position presents no market risk, the
transaction will produce a profit to the firm if the net proceeds 33/
from selling the call and buying the put exceed the cost of carrying
the stock until the expiration of the options.

For example, assume XYZ stock is trading at 50, and the XYZ
50 calls one month prior to expiration can be sold at 2-1/2 and
the corresponding XYZ 50 puts can be bought at 2. Assume further that
the broker-dealers' cost of money is 9 percent. The cost of
owning 100 shares of XYZ until expiration of the options (1/12
year) will be $5,000 X 9% X 1/12, or $37.50. The options position
(short call + long put) will produce net proceeds of 1/2 point
($50). The profit from a conversion arbitrage transaction can
be shown as follows:

3_3/ In determining the "net proceeds" for this purpose, the intrinsic
value (the in-the-money portion) of either the put or call premium
must be subtracted.

151

Proceeds less Cost = Profit

Sell call + 2-1/2 Interest cost of invest- $12.50

Buy DUt ^_2 ing $5,000 for one month

+ 1/2 or $50. to buy 100 shares of

stock - $37.50

Therefore, $12.50 can be earned without risk each time the position can

be established up to a theoretical maximum of 500 times 34/ or $6,000.

To achieve this maximum profit, however, the arbitrage transaction

would have to be effected 500 times at the assumed prices. In practice,

the arbitrage transactions themselves may bring prices back "into

line" fairly quickly, thus limiting the potential profits.

(b) Reverse conversion arbitrage. If a call is undervalued

relative to its corresponding put, reverse conversion arbitrage

is a riskless method of capturing the amount of this undervaluation.

The reverse conversion equation is as follows:

SHORT STOCK + LONG CALL + SHORT PUT = NO MARKET RISK

If the calls are in-the-money at expiration they will be exercised
by the firm to acquire stock to cover the short stock position. If
the puts are in-the-money they will be exercised by the holder. In
either case stock will be acquired by the firm to cover the short
stock position and the out-of-the-money options will expire worthless.

Reverse conversion arbitrage will thus be profitable whenever
the interest which can be "earned" on the proceeds from the short

34/ Under the position limit rules of the options exchanges, the
combined total of short calls and long puts must not exceed
1,000 contracts since these positions are on the same side of
the market.

152

stock sale exceeds the net cost of the long call, short put position.
Normally the interest earnings are expressed in terms of interest
expense saved since the proceeds of the short stock sale are used
to reduce the broker-dealer's outstanding bank borrowings.

Reverse conversion arbitrage can be demonstrated using the
following example: Assume that XYZ stock is trading at 50 and that
the XYZ calls which expire in one month are undervalued with respect
to puts. The calls can be bought at 2-3/8 and the puts can be sold
at 2-1/8 for a net cost to the firm of $25 (1/4 x 100) to establish
the position. If the firm sells the stock short it can earn $37.50
in interest income for each 100 shares sold ($5000 x 9% x 1/12).
This income is offset by the cost to the firm of $25 to establish the
options position, which gives the firm a net profit of $12.50 (37.50 -
$25) each time the position is established. 35/

Proceeds less Cost = Profit

Interest on $5,000 Buy call + 2-3/8 $12.50

for one month derived Sell put - 2-1/8

from selling 100 + 1/4 or $25

shares short - $37^50

An additional cost, however, must be considered by a firm
evaluating a possible reverse conversion opportunity. This is the

35/ The examples in this section assume that there are no dividends
payable on the underlying stock prior to expiration of the
options involved. The cost of carrying the long stock portion
of the conversion position would be offset to the extent dividends
are received on the stock. The interest generated by the short
stock portion of the reverse conversion position will be offset
by payment of any dividends, since the short seller is responsible
for any dividends paid on the stock which he has borrowed.

153

cost of borrowing stock to deliver in connection with the short
sale. Upstairs firms with a significant retail business, however,
hold a substantial amount of customers' margin securities 36/ which
the firm can use, at no cost, to satisfy short sale delivery require-
ments. In fact, these firms employ reverse conversion arbitrage
as a means of profiting from the availability of these securities.
Firms without access to customers' margin securities are largely
precluded from engaging in reverse conversion arbitrage unless
they are able to borrow stock at little cost.

Conversion and reversion arbitrage opportunities are only available
for those 25 stocks which have both listed put and call options.
( 2 ) Hedged short selling

As a result of their access to customers' margin securities,
some upstairs firms engage in an options trading strategy generally
referred to as a "hedged short sale," which involves selling stock
short and buying deep- in-the-money calls. As described below, this
strategy is not technically a hedging or risk limiting strategy,
but a riskless arbitrage transaction. 37/ Hedged short sales as an

36/ From the broker-dealer's perspective, the dollar amount of

the securities utilized is limited to 140 percent of customers'
margin debits, see 17 CFR 240.15c3-3(a) (4)".

37/ The strategy may, however, be employed as a true hedging strategy
of a bearish nature in the more usual case where the premium paid
for the calls (less any intrinsic value) exceeds the interest on
the short sale proceeds to expiration. This excess could be viewed
as the cost Daid for a position that is the equivalent of owning
a put, where a listed out is not available (but at a greater capital
cost) .

154

arbitrage strategy are effected by upstairs firms only when the
interest on the proceeds of the short sale until the expiration
of the options (less any dividends) exceeds the premium on the calls
less their intrinsic value. Intrinsic value is that amount by which
a stock's price exceeds the exercise price of its call. Near ex-
piration deep- in-the-money calls can frequently be bought at parity
(the price at which the short stock sale can be made less the exercise
price of the calls) and there will be no cost offset to the interest
generated (except dividends where applicable) assuming free access
to stock.

For example, in April, an upstairs firm sells short 1,000 shares
of stock at 30, receiving proceeds of $30,000 from the sale. The in-
terest receivable on the proceeds (assuming an interest rate of 9%
for 1 month) is $225. The firm also buys 10 in-the-money calls (the
May 25s) at 5-1/8. The premium on the call in excess of its intrinsic
value is 1/8 or $125 for 10 contracts. Thus, the profit from this
transaction, if the position is held to expiration, is $225 less $125
or $100.

Because of the need for stock to deliver to the buyer's broker
in connection with the short sale, this strategy is not viable for
broker -dealers (trading on or off the exchange floor) without access
to customers' margin securities. Thus, in the example described above,
if a firm had to pay more than $100 to borrow 1,000 shares of stock to
deliver in connection with the short sale, the transaction would be un-
profitable.

155

(3) Merger or exchange otter arbitrage

Upstairs firms will commit their capital to arbitrage transactions
in mergers, exchange offers, and tender offers when the potential returns
exceed the risks that the proposed takeover will not be consummated.
In this type of arbitrage, the firm buys the securities of the company
being sought (sometimes referred to as the "target" company) and sells
short the securities of the bidding company. The firm expects ultimately
to exchange the target's securities for the bidders' securities to
cover the short position in the bidder's securities. The profit, if
any, comes from the spread between the price which the firm paid for
the "target's" securities, and the price it received for selling short
the bidder's securities. 38/ The firm takes the risk that the merger
or exchange offer will not be consummated, in which case it is left
with a large long position in the "target's" securities, which must
be liquidated, and an equally large short position in the bidding
company's securities, which must be covered. There is an additional
risk that the transaction will be delayed, in which case the interest
cost of carrying the long stock position may exceed the potential
profit.

As noted, the firm's profit lies in the spread between the price
of the bidder's securities and the price of the "target's" securities
as modified by the terms of the exchange offer. For example, if company
A offers to exchange its securities, which are trading at $50, on a

38/ This assumes a one-for-one exchange ratio for the transaction.

156

one-for-one basis for the securities of company B which are trading
at $47 through a merger , an upstairs firm might buy B at $47 and sell
A short at $50. Then, if the merger is consummated, he can exchange
his B stock for A stock and thereby cover his short position in A at a
$3 profit less the interest costs of owning the long position in B stock.

upstairs firms may use listed options instead of stock to limit
their capital commitment in particular merger or exchange offer
arbitrage situations. The strategies most frequently used are selling
calls of the bidder, purchasing puts of the bidder, and purchasing
calls of the "target. The use of listed options in merger or exchange
offer arbitrage is merely an alternative to the broker-dealer's use
of stock. Since the standards governing the selection and maintenance
of underlying securities for listed options generally limit the
subject securities to those of the largest, most well-capitalized
issuers options are not as yet used very frequently in merger or
exchange offer arbitrage. Options are seldom used in such situations
because very few companies with listed options are the subject of
tender offers or exchange offers.

Options are also used by arbitrageurs in connection with certain
tender and exchange offers in which less than all the outstanding
stock of the "target" company is sought by the bidder. In such instances,
the bidding company may reserve the right to accept tendered shares on
a oro rata basis in the event that more shares are tendered than
the bidder desires. An arbitrageur may find that less than all of his

157

tendered snares nave Deen accepted and that ne is left holding a long
stocK position, wnicn, until it is liquidated, will be held at market
risK. In order to reouce tnis risx, arbitrageurs may write call op-
tions equal to the numoer of shares they expect to own in the event
that tne oiler is oversubscribed and not all their shares are accepted.
Tnis is uesiyned to provide a hedge against loss on the long stock pos-
ition e^ual to tne amount of tne premium received from the sale of the
call and is viewed by the aroitrageur as the disposition of the long
stocK position tnrouyh tne sale of a "stock equivalent" if the call
options are m-tne-money .

Tne Commission has proposed amendments to Rule 10b-4 under the
Lxcnanye act. Tnat Rule, generally speaking, is designed to prevent a
person Iran tendering stock he does not own, referred to as "short
tendering." 39/ One proposed amendment to Rule 10b-4 would prevent
a person from tendering stock even if he owns listed options to purchase
tnat stocK unless ne nas irrevocably exercised those options. 40/
Tnis amendment would codify the staff's interpretive position
that ownersnip or a listed call does not constitute ownership of
tne underlying stocK and is designed to prevent the same stock from
oeing tendered Dy tne owner of the option and the owner of the stock.

39/ Securities Exchange Act Release No. 14157 (November 9, 1977).

40/ bee proposed Rule I0o-4(a)(3) (definition of "equivalent security")

40-940 O - 79 - 13

158

( 4 ) Discount options arbitrage
Occasional obvious pricing inefficiencies arise between the
prices of listed options and their underlying securities and present
upstairs traders with the opportunity to profit, such as when the
bid price for a stock is greater than the exercise price of an in-
the-money call on that stock- and its premium. 41/ For example, if
the market for an underlying stock is 16-1/8 bid, 16-1/4 asked, and
an in-the-money call with an exercise price of $15 can be bought
for $1 , the options could be purchased for the dollar, exercised at
a cost of $15 per share of stock (total cost $16), and the stock
sold for 16-1/8. The transaction would result in a profit of 1/8,
less transaction costs. Because commission costs would eliminate
the profit from this type of transaction, only those firms who
pay no commission costs can engage in discount options arbitrage.
Opportunities for this type of transaction generally arise near
the expiration date of an options series, when premiums of the
in-the-money series may have been driven below parity due to the
heavy selling of such options by public customers. These customers
sell, rather than exercise, their options to avoid paying the
commission costs involved in exercising the in-the-money options,
acquiring the stock and selling it in order to liquidate the position

41/ In such instances, the call is said to be selling at a "discount
from parity."

159

c . Block trading

One significant impact of increased institutional investor
participation in the securities markets has been the growth of the
number of transactions involving large quantities or "blocks" of
securities. Because the existing markets may be incapable of ab-
sorbing transactions involving large amounts of a security without
causing significant variations in that security's prevailing market
price, some upstairs broker-dealers have developed the ability to
facilitate customers' block transactions by engaging in block
positioning. The term "block positioner" is generally used to
describe a broker-dealer who facilitates the execution of a block
transaction in an equity security by commit ing its own capital to
purchase a part of a customer's block sale order or by effecting
a short sale (or a sale from inventory) to fill Dart of a customer's
block purchase order. The definition of "marketmaker" in Section 3(a)
(38) of the Exchange Act includes block positioners.

Listed options have afforded block positioners a means of hedging
against the risk of loss from the positions they assume when executing
a block transaction order. Typically, the holder of a block of stock,
usually an institutional investor, "shops" a block by calling certain
upstairs firms to see if they have any interest in the block. Before
a broker-dealer agrees to bid for a block, it first attempts to
dispose of the block by finding the "other side" of the order.

160

It successtul, tne broker-dealer may generate brokerage commissions
trau nandling botn sides ot the transaction on an agency basis
witn no coninitjiient ot capital. If a customer cannot be found
tor some or all ot tne otner side of a block order, however, some
oroker-dealers will commit capital in order to purcnase, for their
own account, sane or all of the stock oeing sold by the customer.

It a broker-dealer does purchase all or part of a block it
generally waits to see how the market is affected by the transaction
wniie at tne same time continuing to look for a customer or customers
tor tne other siae of its position. If the "other side" is found,
or it tne market reestablishes the price level for the stock which
existed prior to the execution of the block, the block positioner
can dispose ot tne position witnout the need to use listed options.
It tne dIock cannot be disposed of satisfactorily, tne firm can
oe suoject to significant market risk. It can limit this risk by
selling listed call options (or buying puts) to hedge against this
loss it it is long tne stock, or by buying calls (or selling puts)
it it is short the stock. 42/

bince prospective sellers initiate a large majority of NYSE
block transactions, 43/ tne most common use of options by a block

42/ Ellectmg options transactions with knowledge of an impending

blocK sale of the underlying stock, but prior to the execution of
and public dissemination of tne fact of that transaction, is
referred to as "front-running a block." Depending upon the cir-
cumstances ot a particular transaction, "shopping" a block may
raise tront-running concerns. See intra at 59-64.

43/ See, e.g. , Institutional Investor Study, Vol. 4 at 1507 (1971).

161

trader is to write calls to hedge the risk of loss from a long stock
position acquired from a customer selling a block. Conceptually,
writing in-the-money calls against a long stock position can be viewed
as analogous to shorting stock against a long stock position to achieve
a net flat position. In this hedged position, a decline in the price
of the stock (resulting in a potential loss) would be offset by a
decline in the call premium (making it cheaper to cover the short call
position) and vice-versa. This allows the firm to largely eliminate mar-
ket risk until the long stock and short call position can be unwound.
Using options in block trading carries a cost for the broker-dealer. It
creates a short call position which, like the long stock position, is sub-
ject to the risk of market movements and which must ultimately be liquidated

Certain broker-dealers will position options blocks 44/ for
customers when they receive options orders too large to be executed
on the options floor. Institutional customers using a buy (stock)
and write (options) strategy generally give both the stock and options
orders to the same broker-dealer because of lower commission costs
and the convenience of placing both orders with one firm. These
orders are frequently entered by the customer as contingency orders,
at a net price, with the execution of the stock order contingent

44/ The CBOE deems an option transaction involving more than 100 con-
tracts to be an option block transaction, see CBOE Educational
Circular No. 23 (October 10, 1978).

162

on the execution of the options order, and vice versa. For example,
if XYZ stock is at 26-5/8 and the XYZ 25 calls are at 3-5/8, a customer
might place the order (buy stock, sell calls) for a net cost of
23 and give the broker-dealer discretion to execute the component
parts of the transaction at prices which result in a net cost of
23. In order to obtain the entire order, broker-dealers sometimes
oosition the options being sold by the customer and thus find themselves
in a hedged position (short stock, long call). Some broker-dealers
engaged in a large institutional options business have suggested
that, if more listed puts were available, they might set up a reverse
conversion position (short stock, long call, short put) from their
short stock, long call position to eliminate, rather than simply
hedge, their risk.

In addition to being used to shift some of the risks associated
with positioning blocks, the listed options market is used by many
upstairs firms to generate brokerage commissions arising from the
purchase or sale of equity blocks by their institutional customers.
A broker-dealer with institutional customers will check the depth
of the market for specified options to determine whether a large
number of calls can be purchased at or near or at a discount from
parity. The firm can offer the underlying stock to the customer
knowing that it can, if necessary, acquire the options as a hedge or,
if an in-the-money series is available, simply acquire the options
for the purpose of exercising and selling the stock to the customer.

163

tor example, a tirm might check the market for specified options
to determine whether a large number of calls can be purchased
at or near parity. If sufficient market depth exists, the firm might
indicate on /uitex 45/ that it is a seller of the underlying stock.
It tne notice on Autex results in an expression of buying interest
uy an institutional customer, tne firm can offer to sell the stock
snort to tne customer knowing tnat it can, if necessary, acquire
tne options as a nedge against the short position or, if an in-the-
honey series is avaiiaole, simply acquire the options for the purpose
ot exercising ana selling the stock to the customer.

d. Creation of Synthetic puts. The limited availability
ot listeu puts nas created sane demand from certain institutional
customers and some retail customers tor so called "synthetic puts."
To create a syntnetic put, a firm can sell XYZ stock short, buy
listed XYZ calls and then sell to a customer an unlisted, non-
standaraized put on XYZ stock. 46/ In other words, the firm sells
to the customer the right to sell XYZ stock to the firm on terms
corresponding to those of the listed call purchased by the firm.

4b/ Autex is primarily a communications system that supplements

tne existing communications systems of upstairs broker-dealers.
Negotiation and execution ot orders are not accomplished through
autex.

4b/ This transaction puts the firm in the same riskless position as
a reverse conversion transaction (short stock, long call, short
put = no marKet risk), see supra at 27. The synthetic put,
nowever, would not be included in the position reports to the
options exchanges and tnus may raise concerns with respect to
exchange position limit rules, bee Chapter IV.

164

The "right" sold to the customer is called a synthetic put since
it is similar to a listed put except that it has been created by
the firm through transactions in the related stock and calls. A
synthetic put has no general marketability and is usually sold to
the firm which created it at a price reflecting the then current
prices for the calls and underlying stock. 47/

In addition, broker-dealers who find themselves already in a
short stock, long call position as a result of their block positioning
activities may have the incentive to solicit orders for synthetic puts,
the sale of which will both eliminate the market risk of the firm's
position and earn commissions. Unless done pursuant to an exemption
from the registration requirements of the Securities Act of 1933, the
offer and sale of a synthetic put, like the offer and sale of any
unregistered security, violates Section 5 of that Act. 48/

47/ A firm repurchasing a synthetic put does so by "unwinding" the

transactions (short stock, long call) which "created" the synthetic
put. Thus, it buys stock and sells calls.

48/ In 1973 the Commission proposed Rule 238 under the Securities
Act of 1933 to exempt put and call options from registration
under that Act, subject to certain conditions. See Securities
Act Release No. 5366 (February 8, 1973) and proposed Rule 9b-2
under the Securities Exchange Act of 1934, see Securities Ex-
change Act Release No. 9994 (February 8, 1973). Neither rule
was adopted by the Commission. More recently, in connection
with the trading of listed options on the Amsterdam Exchange
in Holland, the Commission issued a release stating that "in
the absence of [an effective] registration statement or an
appropriate exemption, the public offer, distribution or sale
of such options in the United States is unlawful." See
Securities Act Release No. 5930 (May 11, 1978).

165

3. INSTITUTIONAL INVESTORS

Institutional money managers increasingly have used options
for adjusting portfolio risk/reward parameters. Many institutional
investors have facilities and equipment through which they receive
financial news and market information in the same manner as market
professionals who are members of exchanges. They can obtain real-time
last sale and quotation information when it is disseminated through
the consolidated transaction reporting system. But, unlike upstairs
firms and marketmakers, institutional customers can generally only
react to reports of news developments and market transactions by
giving an order to a member firm who then transmits the orders to
the floor for execution. 49/ Although this time delay may be only
a few minutes, it nonetheless can constitute a substantial trading
disadvantage vis-a-vis those members, especially in an active market
when prices are changing rapidly.

Because institutions are large customers of broker-dealers, they
can obtain, indirectly, some of the advantages possessed by member
firms. They have sophisticated communications systems which frequently
include direct wires to the trading desks of the broker-dealers
used to execute their orders. In order to formulate their trading
strategies, institutional investors use either their own options

49/ But see. e.g. , CBOE rule 6.70. This rule allows institutions
to send their orders directly to the CBOE floor for handling
by floor brokers.

166

pricing models or can obtain such computer generated information

from broker-dealers. Institutional investors are also offered research

information, ideas regarding trading strategies, and portfolio review

and analysis by member firms. They are also able to negotiate relatively

low commissions for the execution of their orders. Even with low

commissions, however, some trading strategies such as stock and

option arbitrage remain generally out of the reach of most institutional

customers because the pricing inefficiencies upon which these arbitrage

transactions are based are normally smaller than the commissions

they pay.

As certain regulatory impediments have been eliminated by the
Comptroller of the Currency, state insurance regulators and the
Internal Revenue Service, listed options are being used more fre-
quently by regulated institutional investors such as bank trust
departments, insurance companies and investment advisors who manage
employee benefit and welfare plans subject to the Employee Retirement
Income Security Act of 1974 ("ERISA"). 50/

The regulatory environment in which these institutions function,
however, has nonetheless substantially affected the way in which
institutional investors use options. For example, an opinion of
the Comptroller of the Currency permits the banks under its jurisdiction

50/ See generally Pozen, Robert C. , "The Purchase of Protective

Puts by Financial Institutions," The Financial Analysts Journal,
July/August 1978.

167

to write calls against assets under management, and has made covered
call writing the predominant options strategy of bank managed fiduciary
accounts. 51/ The use of options in the management of the stock portfolios
of insurance companies is subject to the requirements of state in-
surance regulators which, to the extent they permit any options
transactions, generally permit covered calls to be written and, to
a lesser extent, the purchase of calls. 52/

Investment advisors, including investment advisory subsidiaries of
banks, are generally under fewer restraints than banks and insurance
companies although, in many instances, the nature of the assets under
management restrict the use of options. For example, investment
advisors who manage pension and welfare fund portfolios subject to the
provisions of ERISA generally do not purchase options or write uncovered
options, since many ERISA accounts have bank trustees and are therefore
subject to the Comptroller of the Currency's limitation to covered
writing transactions. While most registered investment companies
do not buy or sell put or call options, they are not prohibited
from engaging in options transactions by the Investment Company

51/ Trust Banking Circular No. 2 (July 2, 1974). The Comptroller
has not explicitly permitted options purchases or uncovered
writing transactions.

52/ For example, the New York State Department of Insurance regulations
state that "Insurers may not purchase any. . .options [other than
in closing transactions]." Insurance Department of the State
of New York, Regulation No. 72, Section 1744.

168

Act of 1940. 53/ Authority to engage in options transactions can
be obtained by a vote of an investment company's shareholders
and some investment companies have begun to use options as part
of their investment programs. Shares of most of these funds are
being offered to investors seeking income. These funds follow a
buy and write program of purchasing option stocks and writing
calls on a one-for-one basis against these stocks.

The Options Study found, based on its interviews with regulated
institutional investors, that a substantial majority of those in-
stitutional investors using options concentrate on writing fully
covered options, with only a small minority engaging in the purchase
of calls in combination with fixed income securities, or other options
strategies. 54/55/

53/ However, the writing of uncovered options (like the purchases

of futures or forwards in contracts respecting financial instruments)
may raise a question as to whether that activity involves the
issuance of "senior securities" by the investment company within
the Drohibitions of Section 18 of the Investment Company Act
of 1940.

54/ This observation is consistent with a survey conducted for
the AMEX in 1976. This survey found that 79 percent of in-
stitutional investors surveyed concentrated on a covered writing
strategy. See, A Summary of Investors In the Listed Options Markets,
Louis Harris Associates for the American Stock Exchange, Inc.,
May, 1976.

55/ Another category of institutional investor is the investment part-
nership or hedge fund". Comments of marketmakers on the options
exchange floors and broker-dealers who execute stock and options
orders from hedge fund customers suggest that a few large hedge
funds have had a significant impact on options trading and
that their size creates a potential for engaging in questionable
trading practices involving the use of options. The Options
Study was unsuccessful in attempting to voluntarily obtain
trading information from hedge funds. Because they do not report
to the Commission and because the Options Study did not use
subpoenas, it was unable to evaluate stock and options trading
practices by hedge funds.

169

4. SPECIFIC TRADING ABUSES

The discussion above focused primarily on the legitimate ways
in which market professionals use options in connection with their
trading strategies. As noted in the introduction, however, certain
questionable trading practices have also been identified as being
associated with options. These practices, discussed in more detail
below, are proscribed by various sections of the Exchange Act, in-
cluding Sections 9(a)(1), 9(a)(2), 10(a), 10(b), and 11(a).

While the discussion below focuses only on those questionable
practices already identified and known to have occurred, variations
of presently known manipulative stock/options trading may be identified
if the surveillance systems of the self-regulatory organizations
are refined, and if information derived from those systems was
better shared among those organizations. 56/

a. Fictitious trades

When a bona fide options trade is made, a report of the trade
is transmitted to the price reporting system of the exchange on
which the trade occurred. In 1976, the AMEX discovered that some
of its marketmakers were "reporting" trades even though no transactions
had occurred. The reporting of these "non-trades", labelled "fictitious
trades," might have been done for a number of reasons, including:

(1) creating a false or misleading impression of trading activity
in an options class to induce others to purchase or sell
options; or

(2) adjusting or updating the last sale price of an option

to conform to the most recent transaction in the underlying
stock; or

56/ See Chapter IV.

170

(3) altering the closing price of an options position to reduce
a trader's financial obligations to its clearing firm. 57/

After discovering the reporting of fictitious options trades
on its floor in 1976, the AMEX notified the Commission of the problem.
Both the AMEX and the Commission took action against the options
specialists involved. The Commission obtained civil injunctions against
nineteen persons and initiated administrative proceedings against
seventeen persons based on the antifraud (Section 10(b)) and anti-
manipulative (Section 9(a)) provisions of the Exchange Act. 58/

b . Prearranged trading

Prearranged options trades may be done for a number of reasons
including (i) the wish to create a false or misleading appearance
of active trading in the options in order to induce others to purchase
or sell the options, (ii) or for tax purposes, or (iii) to create
the appearance of an active, liquid market for the options. Pre-
arranged trades involve the entry of an order by one person to buy
or sell an option with the knowledge that another person will enter

57/ Clearing firms mark their marketmakers' positions to the market
at the close of trading to determine the current market value
of the marketmakers' positions in order to compute their capital
requirements. See Chapters IV and VII. The Options Study staff
is aware of one instance where a marketmaker effected the last
reported transaction or entered the closing quotation, for almost
an entire month, for the purpose of enhancing the value of his
positions which were "marked-to-the-market" by his clearing firm.

58/ Securities Exchange Act Release No. 13453 (April 19, 1977).
The administrative proceedings were subsequently settled,
Securities Exchange Act Release No. 13797 (July 22, 1977).

171

an order of substantially the same size, at substantially the same
time, and at substantially the same price. A variation of the two-party
prearranged trade is the "wash sale," which describes a transaction
which involves no change in the beneficial ownership of a security.

In 1978, the Commission ordered administrative proceedings
in connection with certain transactions which were effected among
marketmakers at the CBOE. 59/ The Commission's staff alleged that
these marketmakers had executed spread transactions to create losses
for tax purposes. In addition to alleging violations of the antifraud
provisions of the Exchange Act, the Commission also charged that
these transactions were not executed by the marketmaker while he
was acting in the capacity of a bona fide marketmaker as required
by Section 11(a)(1) of the Exchange Act.

c. Chumming

The introduction of multiply traded options, that is, of options
classes listed on more than one exchange, created an environment in

59/ Securities Exchange Act Release No. 14330 (January 3, 1978).
The Commission accepted offers of settlement from all but one
of the respondents and issued its findings and order imposing
remedial sanctions. See Securities Exchange Act Release Nos.
14432 (January 3, 1978); 14431 (January 3, 1978) and 14479
February 6, 1978). The initial decision of the administrative
law judge, which found a violation by the remaining respondent,
was issued on August 22, 1978. The administrative law judge
found that the respondent assisted in options transactions
which he knew or should have known were not bona fide and which
operated as a deceit on the public. This decision is presently
being appealed to the Commission.

172

which options exchanges competed for the order flow for those options
from broker-dealers. Because many brokerage firms automatically route
their small public orders for an option to the options exchange with
the greatest volume of trading in that option, marketmakers of options
exchanges appear to have engaged in prearranged trades, wash sales and
trade reversals among themselves to give the appearance of increased
trading volume in the multiply- traded option for the purpose of inducing
transactions in such options on their options exchanges.

The Commission has stated that this practice, called "chumming,"
may violate the antifraud and antimanipulative provisions of the Act. 60/
The Commission issued a release stating its view that options marketmakers
who may have been "increasing substantially their proprietary trading
in certain dually traded options ... [in order] to induce the purchase
or sale of such dually traded options on their options exchanges instead
of other options exchanges on which the same class is traded" may have
engaged in conduct which violates Section 9 and 10 of the Exchange Act.
In addition, the Commission "cautioned [brokers] against relying solely
on aggregate trading volume reported on [options] exchanges" when deter-
mining the market "to which to route their customers' orders." 61/ To
provide better volume data for use in the future as a measure of "the
relative quality of markets," the Commission "arrange [d] for publication
of reports obtained from exchanges trading options regarding proprietary
options transactions by floor members." 62/

60/ Securities Exchange Act Release No. 13443 (April 5, 1977).

61/ Id.

62/ Id. See also Securities Exchange Act Release No. 13448 (April 15,
1977) and No. 13476 (April 27, 1977).

173

d. Stocky option manipulation
(1) Minimanipulation

A relatively small commitment of capital to an options position can
result in substantial percentage gains if a favorable movement in the
price of the underlying stock causes a corresponding favorable movement
in the price of the option. An attempt to influence the price movement
in a stock to benefit a previously established options position is
referred to as a stock/option manipulation. If the attempted mani-
pulation is of short duration, and involves a relatively slight price
movement in the stock, the effect is often called minimanipulation.
The incentive and opportunity for persons to attempt minimanipulations
is demonstrated by the following series of stock and options transactions
which the Commission staff recently alleged were effected by a marketmaker
on the CBOE. 63/

In July, with IBM stock trading at about 260, a marketmaker was
short approximately 200 July 260 calls. The value of his short position
would be enhanced if, by depressing the price of the stock, the marketmaker
could cause a corresponding drop in the price of the July 260 calls.
To accomplish this goal, the marketmaker purchased 50 deep- in-the-money
calls (the July 240s) and submitted an exercise notice with respect

63/ See Securities Exchange Act Release No. 15269 (October 24, 1978).

40-940 O - 'i

174

to these contracts. 64/ He then increased his short position in the

July 260 call options by selling an additional 100 calls at prices ranging

from 2-7/16 down to 2-1/4. Within a few minutes, he sold 3,900 shares

of the underlying stock acquired through exercise of the July 240 calls

at declining prices ranging from 260-1/2 down to 259-1/2. The options

market quickly reacted to the price decline in the underlying stock

and the July 260 calls declined in price permitting the marketmaker

to profitably cover, within a matter of minutes, a substantial part

of his short position in the July 260 calls at prices ranging from 1-7/8

to 2-1/16. While the dollar profit from closing his short options position

was relatively small (generally less than 1/2 point), the profit reoresented

a oercentage gain of between 20-25 percent on an options position initially

valued at slightly over $70,000. The profit was made despite the slight

transaction costs incurred by the marketmaker to sell the stock, and

the small time premium paid to purchase the deep- in-the-money calls.

Because only a small movement in the price of the underlying stock
will result in substantial percentage gains on the related options,
stock/option minimanipulation may even be accomplished without the

64/ The purchase of the deep- in-the-money calls was used by the market-
maker as an alternative (and inexpensive) method of acquiring the
stock needed to sell in an attempt to depress trie market without
subjecting himself to the restrictive provisions of the Commission's
short sale rules, e.g. , 17 CFR 240.10a-l, or to the risk of being
short both the stock and the options. Under options exchange rules
(or interpretations of such ruies), a holder of an option who submits
an irrevocable exercise notice is deemed to be long the underlying
stock. See, e.g., Interpretation .02 to CBOE Rule 11; CBOE Educational
Circular No. 10 (August, 1975).

175

manipulator engaging in any actual stocK transactions. He might prevent
a move in tne stocx price or move the price merely by placing a large
order just aoove or below tne marxet which could momentarily influence
tne price of the stock in the opposite direction.
(2) Capping and Pegging
Ertecting stocK transactions to depress or prevent a rise in the
price or a stock in oruer to prevent near-tne-money , at-the-money,

or siigntly m-tne-iioney call options from being exercised, and to

protect a previously received premium, is referred to as capping. Similarly,

ettecting stock transactions to prevent a decline in the price of a
stocx, in order to assure that put options written on the stock will
not oe exercised and tnat premiums previously received will be protected

is relerred to as pegging. 'Inese practices are most likely to occur
just oetore expiration of the options series, when the probability of
exercise is nignest. Capping and pegging are forms of minimanipulation.
In one Commission administrative proceeding involving capping, 65/
an options specialist held a large snort position (over 2,800 contracts) 66/
in siigntly ln-tne-money calls. Near expiration, he began to sell substantial
amounts ( approximately 25,000 shares) of tne underlying stock short, generally
witnout noting on nis oruer tickets that the stock was being sold short,

65/ bee, In tne flatter of J. Newman & Co. , et al. (Exchange Act
Release No. 14384), January 17, 1978.

66/ Under the position limit rule of the AMEX, the specialist had
obtained an exemption from the limit of 1,000 contracts on one
sioe ot the rnarxet.

176

thus avoiding the prohibition against short sales on "down ticks" 67/ designed
to prevent the acceleration of a price decline. These sales had the effect
of depressing the market price of the stock. The Commission, in ordering
sanctions against the options specialist, found that these short sales
were timed to satisfy and thus counteract buying pressure which would
drive the price of the stock up and that on some occasions the res-
pondents withdrew their orders or instructed their broker to lower
the limits of their previously entered sell orders when other sellers
appeared in the market. As a result of the specialist's short sales,
the price of the underlying stock declined to the options' strike price
at the expiration of the series and the options specialist did not
receive assignments against his short options position. He thereby
protected the premium income he had earned in establishing the short
call position and also avoided the costs he would have had to incur
to acquire or borrow the underlying stock to satisfy an exercise
notice .

( 3 ) Statutory prohibition of manipulation
Section 9(a)(2) of the Exchange Act makes it unlawful

[t]o effect, alone or with one or more other persons,
a series of transactions in any security registered
on a national securities exchange creating actual or
apparent active trading in such security, or raising
or depressing the price of such security, for the
purpose of inducing the purchase or sale of such
security by others. (Emphasis added.)

67/ See 17 CFR 240.10a-l. The term "down tick" is used to describe a
transaction at a price lower than the last previous transaction.

177

The underscored language has raised questions whether the
antimanipulative prohibitions of Section 9(a)(2) apply to trading
in both an option and the underlying stock in different markets,
referred to as intermarket manipulation.

Rather than rely on Section 9(a)(2), other sections of the
Exchange Act -have been cited as prohibiting intermarket manipulative
trading, including Section 10(b) which prohibits the use of "any
manipulative or deceptive device or contrivance" and Rule 10b-5
thereunder which makes it unlawful "to employ any device, scheme,
or artifice to defraud, ... or to engage in any act, practice
or course of business which operates or would operate as a fraud
or deceit . . . , in connection with the purchase or sale of any
security". 68/

The Commission, for example, has proceeded against intermarket

manipulation on the basis of Rule 10b-5. 69/ Similarly, in an

educational circular on the subject of manipulation, the CBOE took

the position that conduct

will be considered to be in violation of SEC Rule 10b-5 and
CBOE rules if it involves inter-market manipulation, whether
options to stock, stock to options, options series to options
series, etc. 70/

68/ CBOE Education Circular No. 22 (September 15, 1978).

69/ See, In the Matter of J . Newman & Co . , et al. (Exchange Act
Release No. 14384), January 17, 1978.

70/ CBOE Education Circular No. 22 (September 15, 1978).

178

Neither the Commission nor the courts, however, has resolved

the ambiguity in the language of Section 9(a)(2) to make clear that

intermarket manipulation, including stock-options manipulation,

is prohibited by that Section. The Options Study believes such

resolution should be made. Accordingly, the Options Study recommends:

THE COMMISSION SHOULD ISSUE AN INTERPRETIVE
RELEASE OR INITIATE RULEMAKING PROCEEDINGS
SPECIFICALLY TO CLARIFY THAT INTERMARKET
MANIPULATIVE TRADING ACTIVITY INVOLVING OP-
TIONS AND THEIR UNDERLYING SECURITIES MAY
VIOLATE SECTION 9.

(4) Problems of proof and the need for data

In discussing the problem of proof of a manipulative purpose

under Section 9(a), the Commission has stated

since it is impossible to probe into the depths
of a man's mind, it is necessary in the usual
case (that is, absent an admission) that the
findings of manipulative purpose be based on
inferences drawn from circumstantial evidence. 71/

The classic stock manipulation typically involved a security

with a relatively small number of shares held by public customers. A

manipulator would slowly acquire a substantial number of shares over

a fairly extended time period to constrict the supply of the stock.

Then, by creating rumors or favorable recommendations about the

company, or by effecting a small number of carefully timed purchases,

the manipulator would cause a substantial increase in the market

price of the stock. A sharp price rise would induce more investors to

71/ The Federal Corporation, 25 SEC 227, 230 (1947).

179

purchase the stock and this trading activity would cause a further

price rise. When the price had risen sufficiently, the manipulator

would complete the manipulative scheme by selling his securities

at the artificially higher prices for a substantial profit.

Options were often found to be an integral Dart of the classic

manipulative* schemes which occurred in the 1920' s and which gave

rise, in oart, to the introduction of legislation which became the

Exchange Act. In those instances, options (generally granted by

the issuer of the underlying securities) were purchased by the

manipulator to provide him, on exercise, with a ready supply of the

underlying stock, which he could then profitably sell into the

market at the inflated prices resulting from his manipulative

activities. Due to the lack of any secondary trading market for

options, there was no attempt by the manipulator to profit by

selling the ootion itself. The existence of options was used as

circumstantial evidence of the manipulative intent of the manipulator,

In an early case- the Commission stated

The very existence of an option when coupled with
buying on the market by those having an interest in
its exercise is an indication of purpose to raise
the market price, to increase market activity and
thus to distribute profitably the stock covered
by the option. 72/

Modern-day stock/options minimanipulations may be of a quite

different character from traditional stock manipulations, and because

72/ Charles C. Wright, 3 SEC 190, 206 (1938), rev'd on other grounds
sub. nom. Wright v. SEC, 112 F.2d 89 (CA 2, 1940).

180

many legitimate strategies involve stock and options transactions,
manipulative intent cannot be demonstrated simply by showing that
a person held both options and related stock. The manipulator may
have established his options position in the course of legitimate
trading and thereafter decided to effect stock transactions in order
to profit from the options position. Since the minimanipulation
requires only a small change in price of the underlying stock for
a brief period, and because of the present difficulty of precisely
reconstructing the actual timing of related stock and options trans-
actions, 73/ manipulative transactions become very difficult to dis-
tinguish from the legitimate activities of market professionals who
are continuously trading stock and options in quantities sufficient
to affect prices of both securities.

The circumstantial evidence necessary to support a charge of
minimanipulation, moreover, is often difficult to establish because
of the existence of several options series in each class and the likelihood
of a market professional holding long and short positions simultaneously
in different series. Transactions which appear to be done with the
intent of benefiting a position in one options series may be explained
as necessary to carry out some legitimate trading strategy. The trader
may claim, for example, that the apparent manipulative transaction
was part of a legitimate hedging strategy entered into solely to limit

73/ See Chapter IV with respect to the difficulties of reconstructing
stock trading on NYSE.

181

market risk in another series. Indeed, surveillance officials at one
exchange indicated that "if we feel there is a logical explanation
[of questionable stock/options trading] we won't bring the case."
This, of course, is not dispositive of whether there has, in fact,
been a manipulation.

The following example of possible minimanipulation demonstrates
a situation in which a trade may be either a manipulation or a
legitimate hedging transaction, depending upon the actual intent
of the trader. A firm's proprietary account was long 147 July 45 call
options, short 167 July 50 call options and short 3,400 shares of the
underlying stock. The firm sold 10,000 shares of stock at 49-7/8 and
50 and then bought 141 July 50 calls to substantially close its short
options position. While the stock sales may have been part of a manipula-
tion to permit the firm to close out the short position in the July
50 series at a favorable price, the firm said its short stock sales
were designed to hedge the long position in the July 45s against a
price decline.

Because of the difficulty in proving alleged minimanipulations,
and the absence of well-defined legal standards in this area, it appears
desirable to examine stock/option trading patterns in greater detail
than has been possible for the Options Study and to determine if certain
trading patterns should be prohibited by rules adopted by the self-
regulatory organizations or by the Commission.

182

Proscriptive rules in this area should be tailored to avoid
unnecessary impact upon legitimate trading activity. The Options
Study understands that the NYSE and options exchanges have agreed
to exchange information which will provide an integrated data
base of stock and options transactions. Such a data base is essential
to a proper analysis of stock and option trading patterns. This
information can be used to determine the need for and the exact
nature of any rules to regulate patterns of related stock and option
trading. In addition, the self-regulatory organizations have
collected new information which may help the Commission and the self-
regulatory organizations to identify trading patterns that may
be appropriate subjects of antimanipulative rules. Accordingly,
the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD USE THE INTEGRATED
SURVEILLANCE DATA BASE THAT THEY ARE ESTABLISHING FOR STOCK
AND OPTIONS TRADING TO DETECT UNLAWFUL TRADING ACTIVITIES
AND CONDUCT APPROPRIATE ENFORCEMENT ACTIONS AND TO IDENTIFY
PATTERNS OF STOCK AND OPTIONS TRADING THAT SHOULD BE REGULATED
OR PROHIBITED. THE COMMISSION AND THE SELF-REGULATORY ORGANIZATIONS
SHOULD WORK TOGETHER TO ESTABLISH PRIORITIES FOR THESE STUDIES
AND THE SELF-REGULATORY ORGANIZATIONS SHOULD REGULARLY REPORT
THE RESULTS OF THE STUDIES THAT THEY CONDUCT TO THE COMMISSION.

Additionally, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD OBTAIN AND REVIEW
ALL INSTANCES OF OPTION AND STOCK TRADING WHICH ARE OR HAVE
BEEN THE SUBJECT OF INFORMAL OR FORMAL INVESTIGATIONS BY THE
SELF-REGULATORY ORGANIZATIONS. THE DIVISION OF MARKET REGULATION
SHOULD REVIEW THIS DATA WITH A VIEW TOWARD PROPOSING ANTI-
MANIPULATIVE OPTIONS AND STOCK TRADING RULES, WHERE APPROPRIATE.

183

e . Front-running

The leverage offered by options, which permits substantial percentage
gains on a small capital investment, and the existence of a liquid market
for options have created new opportunities for profitable options trading
based on non-public market information. One method of taking advantage
of this information is "front-running1 which the Commission has defined
as the practice of trading a security while in possession of unreported
information concerning a block transaction in the same or related
security." 74/ The Commission has stated that such conduct constitutes
an unfair use of non-public market information and is prohibited,
at a minimum, by exchange rules which prohibit conduct inconsistent
with just and equitable principles of trade.

The following is an example of front- running. A block positioner
obtains market information concerning a potential block transaction
in the normal course of his business as a result of an institutional
customer's inquiry concerning a contemplated sale of stock. If a
block positioner is aware of a forthcoming block sale which will
be reported at less than the current market and writes calls before
the price of the calls reflects the block transaction, he would
receive a greater premium than if he had written those calls after
their price moved to reflect the effect of the block sale on the
price of stock and related options. For example, assume XYZ stock

74/ Securities Exchange Act Release No. 14156, November 19, 1977,
(Letter from George A. Fitzsimmons, Secretary, Securities and
Exchange Commission to Joseph w. Sullivan, President, CBOE).

184

is trading at 50 and a call option with a strike price of 50 and with
one or two months to expiration is trading at 2. Assume further that
a block positioner, knowing that he is going to bid 49 for a block
of 30,000 shares of XYZ stock, sells 300 XYZ 50 calls at 2 and subse-
quently executes the equity block transaction at 49. The purchasers
of the calls, however, would not have paid $2 if they knew that a
block of the underlying stock was going to trade at 49, which would
likely have caused a drop in the price of the option.

While option trading based on such market information may permit
a block positioner to hedge his risk and thus make a better bid to a
customer, it gives the block positioner a market information advantage
over other market participants. Trading based on that market information
is inconsistent with the notion of fair and honest markets and just
and equitable principles of trade. 75/

75/ In the above example, the block positioner was trading on the
basis of his customer's stock orders. It would, of course,
also be possible for a market participant to trade options
after deciding to purchase or sell a substantial amount of
the underlying stock for his own account but before effecting
the stock transactions. The Commission has not yet specifically
considered whether "self -front-running" is inconsistent with
just and equitable principles of trade or the antifraud provisions
of the Exchange Act. Nonetheless, "such behavior on the part
of persons with knowledge of imminent transactions which will
likely affect the price of the derivative security [may constitute]
an unfair use of such knowledge." Securities Exchange Act
Release No. 14156, supra.

185

Although the most obvious instances of front-running occur after
all the terms of the block transaction have been agreed to, front-
running may profitably occur at an earlier time. For example, knowledge
that there is either a buyer or a seller of a block may provide a
front-running opportunity even without definite knowledge of the price
at which the block will trade. Block trades initiated by buyers and
sellers have been found to accompany a change in the market price
of the underlying stock by about one percent upward and downward,
respectively (as measured from the previous close to the close
on the day of the block transaction). 76/ Accordingly, while
the propriety of such transactions can best be evaluated on a case-
by-case basis, it would appear that front-running can and should
be found to have occurred in instances where the firm effecting
the options transactions has sufficient market information concerning
a particular potential block transaction to permit it a material
advantage over other market participants.

76/ Institutional Investor Study, Volume 4, p. 1825. (1971). The

findings of the Institutional Investor Study predate the commence-
ment of listed option trading. Listed option trading may have
reduced somewhat the amount of price movement associated with
stock transactions in underlying stocks because of the ability
of block positioners to reduce risk by using options, although
no conclusive evidence is yet available.

186

Broker-dealers follow disparate practices regarding their treatment
of front-running. After the CBOE filed its proposed front-running rule
in 1976, 77/ some firms adopted " in-house" rules (generally unwritten)
prohibiting front-running. These rules vary as to the timing of the
option transaction relative to the dissemination of information regarding
the stock transaction, the method of disseminating the information
regarding an impending block transaction, the definition of a block,
and the price of the block in relation to the current market for the stock,
This lack of uniformity highlights the need for a regulatory pro-
hibition against front-running which applies the same standards
to all market participants.

To date no disciplinary actions have been completed by any options
exchange in the area of front-running, although instances of possible
front-running have been detected by the exchanges through their existing
surveillance programs. Inaction by some self-regulatory organizations
seems to have been either a result of a difference of opinion regarding
the unfairness of front-running activities, inadequate exchange rules,
or lack of a precise definition in this area. For example, in the
past the AMEX has not initiated disciplinary actions against its members
when instances of apparent front-running have been detected. Rather,
they have accepted the argument that the option transaction, when ex-
ecuted prior to the block transaction, is an appropriate hedging strategy

77/ Securities Exchange Act Release No. 12400 (May 3, 1976).

187

Dj tne uIock positioner. Tne Ai*lLX, nowever, has recently revised
its policy on tne subject of front-running and no longer views the
neaging argument as a valid rationale for a members' front-running
conduct. Mitnougn its oy-laws prohibit conduct which is inconsistent
witn just and equitaole principles of trade, 78/ the PHLX, prior
to tne Commission's release in Novemoer, 1977, 79/ failed to proceed
against front-running on tne tneory that its rules only prohibit
memoers' trading based on non-puolic market information obtained
on tne tloor bit/ and tne marxet information regarding a pending
oiocK is lnvariaoly obtained upstairs as a result of an institutional
customer's inquiry. Tnis rationale, nowever, snould no longer
prevent tne initiation of enforcement procedings in the area of
iront-running.

Tne CdUE, which also detected instances of front-running by its
memoers, first attempted to proceed against the practice by rulemaking.
Alter an initial rule tiling with tne Commission, and receipt of the
Commission's consents, tne CbUE witndrew its proposed rule and issued
an educational circular for its members concerning the applicability
to front-running of existing CBOE Rule 4.1, which prohibits conduct
oy members which is inconsistent with just and equitable principles
of trade. 81/ Tne educational circular contains a discussion and

7b/ bee PriLX tsy-Laws, Section 18-7.

79/ bee note 74, supra.

bu/ bee PttlX rule iDlb.

81/ CtXJt, ideational Circular No. 23 (October 10, 1978).

188

examples of conduct involving front-running of blocks that the CBOE
considers to be a violation of its Rule 4.1. The circular also
makes it clear that, while it concentrates on members' proprietary
trading, certain situations, such as where a member passes on non-public
information concerning block transactions to a customer who then trades
on the basis of the information, may also result in a violation of the
CBOE's prohibition against conduct which is inconsistent with just and
equitable principles of trade.

The CBOE circular states that front-running may be based upon
knowledge of less than all the terms of the transaction, if there is
knowledge that all the material terms of the transaction have been or
will be imminently agreed upon. Transactions over 10,000 shares are
conclusively deemed to be blocks and transactions of less than 10,000
shares may be deemed blocks in appropriate cases.

The issuance of an educational circular, such as the CBOE circular,
is an appropriate first step by a self-regulator to provide guidance
for its members on the subject of front-running. Front-running
is an appropriate subject for regulatory attention and definition
in order to put market participants on notice regarding the bounds
of permissible conduct.

Accordingly, the Options Study recommends:

ALL SELF-REGULATORY ORGANIZATIONS SHOULD (1) ISSUE INTERPRETATIONS
OF THEIR RULES TO MAKE CLEAR THAT FRONT-RUNNING IS INCONSISTENT
WITH JUST AND EQUITABLE PRINCIPLES OF TRADE BY ITS MEMBERS
AND, (2) TAKE PROMPT DISCIPLINARY ACTION AGAINST THOSE MEMBERS
WHO HAVE BEEN FOUND TO HAVE ENGAGED IN FRONT-RUNNING.

189

Another method of taking advantage of market information
regarding the underlying stock through transactions in the options
markets is referred to as tape racing, which refers to the trading
of options based on last sale information regarding the underlying
stock before such information has been disseminated over the con-
solidated transaction reporting system. Tape racing is made possible
by inefficiencies in the system by which information regarding
executed trades in underlying stock is transmitted from the floor
of the exchange (generally the NYSE) where the underlying stocks are
traded. Persons who observe trades or have access to last sale
information before it is disseminated may be able to transmit
options orders reflecting that information to the floors of option
exchanges and have such orders executed at favorable prices prior to
the availability of the last sale information on the consolidated
transaction reporting system.

Tape racing appears to have been largely eliminated by speeding
the process of entering transaction information into the consolidated
transaction reporting system and the availability of last sale
information from the NYSE.
5. TRADING RULES

a . Position limit rules

Each options exchange has rules which prohibit any account
from having a position in excess of 1,000 contracts on the same

40-940 O - 79 - 15

190

side of the market. 82/ These rules were adopted by the options exchanges
primarily to minimize manipulative potential and to prevent the accumulation
of large options positions that, if exercised against uncovered writers,
would cause them to buy the underlying stock which would likely affect
the price of the underlying stock. The position limit rules have the
additional effect of limiting the financial exposure of market participants.

The present position limit rules prevent certain larger investors
(primarily institutions) from writing calls or buying puts against
more than 100,000 shares of stock. As a result, the managers of cer-
tain large portfolios do not presently use options because writing
options up to existing position limits does not provide significant
risk limiting caoabilities for such large portfolios. To the ex-
tent that large investors own the stock underlying the options
they write they need not purchase stock to deliver on exercise
of the calls they write or the puts they buy and, therefore, may
not need to effect transactions which will substantially affect
stock prices. As a result, a significant portion of the theory
underlying the position limit rules may not be aDplicable to such
covered investors.

82/ CBOE rule 4.11, which is typical of these rules, prohibits a
member from making an opening transaction for any account in
which it has an interest or for the account of any customer if
the transaction would result in "an aggregate position in excess
of 1,000 option contracts (whether long or short) of the put
class and the call class on the same side of the market covering
the same underlying security."

191

Further, market liquidity may be adversely effected by the
present level of position limits. For example, proprietary option
trading by member firms is limited to the extent that positions in
excess of 1,000 option contracts on any side of the market cannot
be established. Since other proprietary option business may be con-
ducted by the firm at the same time, its position limits may be

used up through different option activities, including hedging
block transactions or arbitrage, thus precluding other options
transactions.

In addition, numerous market participants, including professional
traders, institutional investors, and self-regulatory organizations,
have maintained that the position limit rules should generally be
liberalized or otherwise modified. Further, the ability of some
self-regulatory organizations to grant their marketmakers exceptions
from this rule and the manner and frequency with which exceptions
have been granted, has raised concern that the rule currently has
an unequal impact on members of different self-regulatory organizations
It has been suggested that either the rules be made uniform for all
market participants or that the self-regulatory organizations be
permitted to liberally grant exceptions, especially in instances
where a marketmaker might otherwise violate the rule when fulfilling
his obligation to trade with Dublic customers.

There are a number of approaches which might be followed if
modification or position limit rules is deemed appropriate. Cne

192

would be to completely eliminate such restrictions, thereby per-
mitting option positions to be established without limitation.
Another would be to increase the level of position limits to 2,000
contracts (or some other amount). Alternatively, a sliding scale
position limit rule could be imposed based on the liquidity, trading
volume or price of the underlying security. Different position
limits for hedged positions as opposed to unhedged positions 83/
might be employed on the theory that the former offers less manipulative
potential than the latter. 84/ Finally, consideration could be given
to establishing position limits based on a financial integrity
standard, i.e. , well-capitalized firms might have a lesser restriction
than dealers whose capitalization is below some specified amount.
Accordingly, the Captions Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD UNDERTAKE A COMPLETE
REVIEW OF THE POSITION LIMIT RULES OF THE OPTIONS EXCHANGES.
THIS REVIEW SHOULD INCLUDE: (1) THE POSSIBILITY OF ELIMINATING
POSITION LIMIT RULES, (2) THE FEASIBILITY OF RELAXING POSITION
LIMIT RULES FOR (a) ALL MARKET PARTICIPANTS, (b) FOR ACCOUNTS
WHICH HOLD FULLY PAID, FREELY TRANSFERABLE SECURITIES OR (c) FOR
"HEDGED" POSITIONS, AND (3) WHETHER EXCEPTIONS FROM THE RULES
SHOULD BE GRANTED TO OPTIONS SPECIALISTS AND, IF SO, UNDER
WHAT CIRCUMSTANCES.

83/ Under the rules promulgated by the Commodities Futures Trading
Commission, positions which are deemed to be bona fide hedging
transactions (as defined) are exempted from position limit
rules, see, e.g., 17 CFR 150.1 (c)(i).

84/ The manner in which hedged positions may be established and
eliminated may, however, present questions with respect to
self-front- running. See note 75, supra .

193

b. Restricted options rules

As a result of concerns raised by the Commission shortly after listed
options trading began, the options exchanges adopted so-called "restricted
option rules" which were designed to prevent unwarranted speculation in
deep-out-of-the-money options. The rules prohibit customers and firms
from entering any order for an opening transaction (purchasing or writing)
in any option which is more than $5 out-of-the-money and is trading
for less than $.50 per unit of trading. There are certain exceptions
for covered writing transactions, spreads and marketmaker transactions. 85/

The rules are premised on a belief that as options become deep-out-
of-the-money, they may be improperly sold to public customers who do
not understand the high probability that the options will expire worthless.
In view of its findings, as described in the Chapters V and VT, the
Options Study concurs in these concerns. Nonetheless, as the options
trading markets have expanded, new uses for restricted options have
been developed. Numerous market professionals have advised the Options
Study that currently restricted options could be utilized in a variety
of ways.

For instance, although spreads in which an equal number of options
contracts are purchased and sold are excepted from the restricted
options rules, it is not possible to alter the risk/ reward parameters

85/ See, e.g., CBOE rule 4.17(b) and (c)

194

of such spreads by purchasing or selling additional restricted options.

One commentator, an investment advisor who uses options extensively,

described a spread involving the purchase of an out-of-the-money option

which might be restricted and the sale of a lower strike price option

and stated:

A potentially more rewarding, as well as prudent
strategy would be to buy several of the restricted
options for every single lower strike price option
sold. 86/

Further, the restricted options rules result in pricing inefficiencies

and a loss of liquidity. When a previously unrestricted option becomes

restricted, a holder of such option is left with a limited market because

a large number of potential buyers is barred from the marketplace. This

lack of liquidity has also affected potential buyers. The trader at one

large investment advisor to a number of investment companies told the Options

Study that:

we have occasionally encountered difficulty in
repurchasing a substantial number of [restricted]
options because the dealer is unable to position
such options because of the restricted option
rule. 87/

In addition, a recent study demonstrates that the purchase of deep-

out-of-the-money options with a small portion of an investor's capital

while placing the remainder in money market instruments is a relatively

conservative strategy which would have proved viable over the 12 year

86/ Letter dated September 20, 1978 from F. Martin Koeing, Chase
Investors Management Corporation New York, in response to
Securities Exchange Act Release No. 14854 at 11.

87/ Letter dated August 18, 1978 from Richard F. Palmer, Colonial
Management Associates, Inc. to Kenneth S. Spirer, Assistant
Director, Options Study.

195

period tested. 88/ However, the general strategy of buying calls in
connection with the purchase of money market instruments has been
infrequently used by public investors. 89/

The regulatory concerns underlying the restricted options rules relate
in large part to desires to protect investors who may not fully appreciate
the risk involved in purchasing deep-out-of-the-money options. The Options
Study has made a number of recommendations designed to insure that options
customers will understand the risks of option trading and to improve the
internal procedures of broker-dealers in furtherance of this objective. 90/

The Options Study believes that improvements in the customer suitability

area may, at a future date, allow the elimination of the restricted options

rules. Accordingly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD CONSIDER THE
ELIMINATION OF THE RESTRICTED OPTIONS RULES AS SOON AS THE
OVERALL EFFECTIVENESS OF THE OPTIONS STUDY'S SUITABILITY
RECOMMENDATIONS CAN BE EVALUATED.

88/ Merton, Robert C. , Scholes, Myron S., and Glads te in, Mattnew L. ,
"The Returns and Risk of Alternative Call Option Portfolio
Investment Strategies," The Journal of Business, April 1978.

89/ See note 54, supra.

90/ See Chapter II.

CHAPTER IV

SELF-REGULATORY ORGANIZATION SURVEILLANCE

OF THE STANDARDIZED OPTIONS f'ARKETS

I. INTRODUCTION

Market surveillance is the orocess of detect ing trading practices that
mav be inconsistent with the Securities Exchange Act (the "Act"), the
rules and requisitions thereunder, and the rules of self-regulatory
oman izat ions. Self-r^qulatory orqanizations engage in surveillance
activities because, amonq other reasons, the Act assigns them responsi-
bility, subject to Co^nission oversight, for assuring that their markets
are fair, honest, and orderly and that their members comply with the
federal securities laws. Specifically, Section 6(b) of the Act states:

(b) An exchange shall not be registered as a national
securities exchame unless the Commission determines that —

(1) Such exchanqe is so organized and has the capacity
to be able to carrv out the purposes of [the Act] and to
comoly, and ... to enforce compliance by its members and
oersons associated with its members, with the provision of
[the Act] , the rules and regulations thereunder , and rules
of the exchanqe .

(5) The rules of the exchange are designed to prevent fraudulent
and manioulative acts and practices, to promote just and equitable
nrinciDles of trade, to foster cooperation and coordination witn
oersons engaged in regulating . . . securities and, in qeneral, to
orotect investors and the public interest ....

(197)

198

(6) The rules of the exchange provide that . . .
its members and persons associated with its members
shall be aooronriately disciplined for violation of
of the provisions of [the Act] , the rules or regula-
tions thereunder, or the rules of the exchange, by
exnulsion, suspension, limitation of activities,
functions, and oner at ions, fine, censure, being sus-
oended or barred from being associated with a member,
or anv other fitting sanction.

In addition, Section 19 (q) of the Act nrovides:

(a)(1) Everv self-requlatorv organization shall
complv with the provisions of this title, the rules and
regulations thereunder, and its own rules, and . . . absent
reasonable iustif ication or excuse enforce compliance —

(A) in the case of a national securities exchange,
with such orovisions by its members and persons
associated with its members;

(B) in the case of a reqistered securities
association, with such orovisions ... by its
members and oersons associated with its members. . . .

This chanter will discuss the surveillance systems that the self-

reoulatorv orqanizations currentlv use to detect improper trading activities

in the standardized options markets and related trading that may occur in

the markets for their underlving stocks. In particular, it will describe

and analvze the sufficiency of the information that the options exchanges

and the New York Stock Exchange ("NYSE") have available and use for surveillance

nurnoses. It will also evaluate the effectiveness of the techniques

that these exchanqes use to detect potentially improper option and related

stock and ootion tradinq. 1/ The NYSE will be the only stock exchange

_1/ Aopendix Exhibit 1 contains a description of the operations of each
options exchanqe and the NYSE. It focuses on the order execution,
or ice report ina, and trade match and comparison processes. In
addition, this Aopendix Exhibit discusses and describes the specific

(footnote continued on next page)

199

whos<^ surveillance information and techniques will be considered because
option prices are qenerally based upon the prices at which a stock is
tradinq on the NYSE. As a result, stock activity that has the purpose
of benefitinq option positions and option activity designed to benefit
from market information about stock transactions that have not yet occurred
are most likely to involve stock transactions on the NYSE.

The detection of tradinq that may be inconsistent with the federal
securities laws can not, however, be the end of surveillance. When
such trad inn is detectel, it must be investigated to determine whether
the Act or self-requlatory organization rules have been violated.
Moreover, where violative conduct is found, the federal securities laws

(footnote continued)

surveillance technioues that the options exchanges use to detect
tradinq practices that may be inconsistent with the Act or exchange
rules.

Amend ix Exhibits 3-19 contain working papers and investigative reports
that the self-requlatory organizations prepared. Many of tiiese
investiqations have been not concluded, and, as a result, many of them
are nonpublic.

Amendix Exhibit 20 also contains certain nonpublic information.
This Anoendix Exhibit contains (i) a summary of the parameters that
the options exchanges use to define trading activity that will
be scrutinized on a regular basis, (ii) a table summarizing the
number of full- and part-time employees at each options exchange
who Perform surveillance functions, (iii) a table of the expenditures
of each options exchange for surveillance purposes, and (iv) a
table of option volume on each options exchange.

Because much of the information that these Appendix Exhibits contain is
nonpublic, they have been bound separately and will not be publicly
disseminated. Copies have been provided, however, to the Commission,
its staff, and the self-regulatory organizations.

200

and self-regulatorv orqanization rules must be enforced and the conduct
sanctioned with a view toward punishing the violator and deterring future
violations. Recognizing that detection is merely the first step toward
fulfilling its statutory obligations, each options exchange has programs
to invest iqate potentially improper trading practices that its surveillance
system reveals. Each exchange also has programs to enforce compliance
with the law when violations are apparent. This chapter will evaluate
the adecuacy of these investigation and enforcement programs.

rianv of the surveillance techniques described in Appendix Exhibit I
are relativelv new. In fact, the self-regulatory organizations developed
many of these technioues durinq the last year, perhaps as a result of
the concerns that the Commission expressed in October , 1977 regarding
"the present abilitv of the self-regulatory organizations' surveillance
svstems to detect and prevent fraudulent, deceptive, and manipulative
activity, both in options and in underlying securities, in a manner
which is consistent with the maintenance of fair and orderly markets
and the protection of investors and that complies with the requirements
of the Act." 2/ While the self-regulatory organizations have improved
their surveillance programs significantly since October, 1977, tnis chapter
will suqnest additional steps that the self -regulatory organizations and
the Commission should take to improve further self-regulatory organization
surveillance of the standardized options markets.

2/ Securities Exchange Act Release No. 14056 (October 17, 1977).

201

II. METHODOLOGY

The Ootions Study analyzed the surveillance systems of the options
exchanges in three phases. In the first phase, each of the exchanges was
asked to suoolv information concerning, among other things, the ways
in which thcv process and provide for the execution of orders on their
tradinq floors, assemble surveillance information, and conduct surveillance
activities. The information that the exchanges submitted in response
to the Ootions Studv's reouest was used to prepare a summary of the operations
and surveillance svstem of each exchange. The systems of the various
exchanges were then comoared to determine what similarities and differences
miqht exist.

The second ohase consisted of a detailed on-site inspection of each
ootions exchange . The our pose of these inspections was to assure that
the Ootions Studv had a comolete understanding of the surveillance system
of each exchanqe and to determine the extent to which the exchanges were
following the procedures that they had described in response to the Options
Studv's reouest. To conduct these inspections, an inspection outline was
orepared for each exchange. Tne outline identified the data and files
that the Ootions Studv planned to examine, the purpose for examining each
set of files, and the items that each file should have included to constitute
a surveillance inouiry consistent with the procedures that the exchange
had described. After the outlines were prepared, an information request
was sent to each exchange asking that the exchange make available for

202

inspection the data and files specified . Hie inspection outline and in-
formation recuest that were used to inspect the CBOE are included in
an Apnendix Exhibit for illustrative purposes. 3/

The inspections of the exchanqes varied in length. The exchanges
that have the most option volume were aiven the most time. Approximately
200 nerson hours were spent at both the CDOE and the AMEX. Approximately
40 oerson hours were spent at the PSE and PHLX. The MSE inspection took
annroximatelv 16 nerson hours.

Finally, the Options Study inspected the NYSE for the purpose of evaluating
its abilitv to reconstruct stock trading that takes place on its floor.
The Options Studv focused exclusively upon this aspect of the NYSE surveillance
program because effective detection and investigation of related stock and
options tradinq qenerallv reouires that the parties, terms, and time of stock
orders and trades be identified and that stock transactions be sequenced
accordina to the times that they occurred. Approximately 16 person hours
were spent at the NYSE and approximately 10 market reconstructions were
reviewed .

At each exchanqe the Options Studv discussed surveillance techniques
and particular cases with senior exchanqe officials responsible for
surveillance activities. In addition, the Options Study spoke with
staff members at each exchanqe who performed daily surveillance functions

3/ Appendix Exhibit 2. This Appendix Exhibit has been bound together
with the nonpublic Aooendix Exhibits. See n.l, supra.

203

and discussed specific inquiries and investigations with the exchange
staff members who conducted them. The Study did not have sufficient
time or resources, however , to investigate independently questionable
conduct that the exchanqes detected or to review substantial amounts of raw
surveillance information for the purpose of determining whether each exchange
had detected everv instance of potentially improper conduct that may have
occurred in its marketplace.

III. SURVEILLANCE INFORMATION

1. The Sources of Surveillance Information

There are four basic sources of market surveillance information. The
first source is transaction information. Transaction information is
derived from the process of trading. At the options exchanges and the
NYSE, transaction information is generally obtained from documents
oroduced on the trading floor. It contains information identifying the
brokers who have executed a trade, the firms that will clear the trade,
the price at which the parties have agreed to buy and sell, the number
of shares or contracts involved in the transaction, and the time that
the trade was entered into the price reporting system of the exchange.
In addition, transaction information can include bid and ask prices
for a stock or oDtion. Bid price information in a market identifies the
orices at which market participants are willing to buy the securities,

204

and ask Drice information identifies the prices at which market participants
are will inn to sell the securities. The transaction information of the
options exchanges may also contain an indication of the most recent price
at which the stock underlying a class of options was sold.

The second source of surveillance information is derived from the
clearinq process. Clearing involves, amonq other things, the matching
of buv and sell orders after a trade has taken place. This matching
is necessary to assure that, where appropriate, buyers pay for and receive
the securities that they bought and that sellers are paid for and deliver
the securities that they sold. Tb accomplish this matching and bookkeeping,
clearing corporations must know who has traded with whom, at what price,
and in what volume. Accordingly, clearing information identifies at
least the clearing firms that represent the buyers and sellers of securities,
the number of shares or contracts that they have agreed to trade, and
the price at which the trade has occurred. Transactions that are submitted
for clearing late or that are not submitted for clearing at all can
usually be ascertained by comparing clearing information to transaction
information.

The standardized options clearing process contains additional infor-
mation. The Options Clearing Corporation ("OCC") clears all standardized
ootions transactions and is organized differently from the stock clearing
corporations. The most significant difference from an informational
point of view is that the OCC has established three types of accounts

205

in which trades can be cleared: customer, marketmaker , and firm proprietary
accounts. Trades in which member firms act as a dealer or principal,
other than in a marketmakinq capacity, should clear only in firm proprietary
accounts. Trades in which exchanqe members act as marketmakers should clear
in marketmaker accounts. 4/ At each clear inq firm, trades effected on
behalf of customers should clear on an aqgreqate basis in one customer account
Broker-dealer firms that are not members of OCC will carry their transactions
in such customer accounts. As a result of this account system, OCC
clear inn information allows one to determine whether trades were cleared
for a customer, marketmaker, or firm. 5/

In addition, the clear inq process can provide the exchanges with
information identifyinq the buyinq and sell inq broker for each traae
that is cleared, the marketmaker account for which a floor broker executed
a trade, the clear inq firm that will actually clear the trade if that
firm is not a member of the exchanqe, and whether the trade was an openinq
or closina transaction if in a customer or firm proprietary account.
Ooenina transactions are those in which an option position is beinq
increased or established, and closinq transactions are those that reduce
or eliminate an existinq oDtion oosition. Marketmaker accounts are maintained

_4/ See Anoendix Exhibit 1 at on. 1-13 for a discussion of the various
tvoes of on-floor marketmakers. Only on-floor marketmakers may
clear ootion transactions in a marketmaker account.

_V OCC, of course, will clear a trade in the account for which the
trade is reported. As a result, if a firm's trade is reported,
due to error or improper nurpose, as a customer's trade, OCC
may clear the trade in a customer account.

40-940 O - 79 - 16

206

op a not basis and therefore do not indicate whether marketmaker trans-
actions are oneninq or closinq positions.

The third surveillance information source is kept at broker-dealer
firms and relates to the accounts that the firms maintain. Account infor-
mation is reauired to contain the specific identity of the customer,
marketmaker, or firm account for which a trade was done as well
as a record of the tradinq activity and positions of each such account.
A record of the time of entrv and terms of all orders for an account
should be maintained, and the Drice and volume of any executions
that are received should be available. The time of entry is the
time that a firm receives or transmits an order for execution. In
addition, a record of the time at which a reoort of execution was received
should be maintained. Commission rules require that firms keep books
and records which include this information. 6/

Finallv, surveillance information may be obtained from customer
or member complaints, reports bv exchanqc members or employees, companies
that have issued securities, the news media, members of the financial
communitv, and other self-requlatory orqanizations. Exchanqe rules
often reouire members or employees to file reports of unusual tradinq
activitv that thev observe.

Table 1 summarizes the data that can be derived from transaction,
cle^rim, and account information.

6/ 17 CFR 240.17a-3 and 240.17a-4.

207

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208

2. The Organization and Capture of Surveillance Information

a. Transaction Information

The CBOE, PSE, PHLX and MSE capture transaction information from
the trade reoortinq process on the trading floor. The information is
obtained from order or transaction price reporting tickets that these
exchanges collect when trades occur. In general, floor brokers report
their trades on order tickets, and marketmakers report their trades
on transaction or ice reoorting tickets. The information that the tickets
contain is key ounched directly on the trading floor into an exchange
comouter for surveillance and other purposes. This information is used
to oreoare comouter reports of transaction information.

The CBOE transaction report may be used to illustrate the trans-
action information that these options exchanges typically capture. The
CBOE transaction report is called the Market Data Retrieval Listing
("MER"). 7/ The MER identifies the date the trade took place, the options
class and series that was traded, the time the trade was entered into
the CBOE Drice reportinq system, the price to which the parties agreed,
the number of contracts involved in the trade, the buying and selling
brokers, chanqes in the bid and ask prices for the options, the last
sale or ice of the underlyinq stock when the option trade was reported,
and whether the trade was reported out-of-seguence , late, or involved

7/ Exhibit 1 contains examples of MDRs.

209

a spread or straddle which received priority over the book. It should
be noted that the time that a trade is entered into the price reporting
system is not the time that the trade actually occurred. There is
inevitably some delay between the time that the parties agree to trade
in a trading crowd and the time that an order or transaction price
reporting ticket is transmitted to an exchange employee and is key
punched into the price reporting system and the exchange computer. 8/
This delay is not uniform among all orders and may result in the reporting
of some trades in a sequence that is different than the sequence in
which the trades actually occurred.

Transaction information at the AMEX and the NYSE is significantly
less complete than at the CBOE and the other options exchanges. The
Daily Journal Report ("AMEX Journal") is the computerized report of
options transactions that are entered into the price reporting system of
the AMEX. 9/ This report indicates for each option series, in time sequence,
the time that each trade was entered into the price reporting system
of the exchange, the number of contracts traded, and the price at which
the trade occurred. Changes in the bid and ask prices for the options
are also reflected, as is most recent sale price of the underlying
stock. The times that . a Journal indicates that transactions
occurred are more likely to pproximate the time that the parties actually
consummated the trade than the time that trades are entered into the

_8/ See Appendix Exhibit 1 at pp. 43-46.

_9/ A page from the AMEX Journal is shown in Exhibit 2.

210

price reporting system at tne otner options exchanges. This is because
amux trades are entered into its price reporting system by a reporter
stationed in tne trading crowd rather than by exchange employees who
must wait tor members to turn in order or price reporting tickets. For
tne same reason, tne AmEX Journal is likely to reflect more accurately
tne actual sequence of trades. 10/

Information identifying the options transactions in which AMEX
specialists and registered option traders ("ROTs") participated as principal
are addea to tne Journal on the basis of reports that the specialists and
KUi's are required to tile at the end of each trading session. The reports
list, among otner tnings, each specialist or ROT option transaction and
tne specialist's or ROT's report of the time that the trade took place.
Tnese reports are prepared manually and are integrated onto the Journal
oy computer to tne extent that they are legible and the times and volumes
tnat tne reports contain match the times and volumes of reported transactions.
It tnese items do not match, the information on the reports must be reconciled
and added to tne Journal manually. As AMEX volume has increased, it has
oecome necessary to add approximately 80% of all specialist and ROT option
transactions to tne Journal Dy hand. Fifteen clerical people require
a tull day to integrate transactions onto the Journal wnen AMEX trading
volume is normal. Of course, options trades that specialists or ROTs
do not report can not be identified in the Journal.

1U/ See Appendix Exhioit 1 at pp. 21-23.

211

The NYSE Daily Transaction Journal ("NYSE Transaction Journal")
contains even less transaction information than the AilEX Journal. 11/
It lists, in time seouence for each stock, the time that the trade
was entered into the or ice reportinn system, the price that was reported,
and the number of shares traded. Changes in the bid and ask prices
for the stock are also shown. Each hour of trading is contained in
a separate column and the minutes during which trades occurred or oid
or asked Drices were changed are indicated at the right of each
column. Information identifying the trades in which the NYSE specialists
and registered traders and marketmakers participated as principals,
while available on forms that they prepare on a daily basis in accordance
with exchanqe rules, is not routinely integrated onto the Transaction
Journal. Nor are trades that occur by means of the Intermarket Trading
Svstem ("ITS") or the Designated Order Turnaround System ("DOT")
reaularly integrated onto the Journal. 12/

It should be noted that neither the AMEX Journal nor the NYSE
Transaction Journal reqularly identifies the parties that participate
in each trade. This is because these exchanges, unlike the CBOE and
the other options exchanges, do not collect order or transaction
Drice reporting tickets when a trade occurs. Thus, the AMEX and the

11/ A oaqe from an NYSE Transaction Journal is provided in Exhibit 3.
12/ See Aooendix Exhibit 1 at pp. 67-72.

212

MYSE can not capture for routine surveillance purposes the information
that such tickets contain.

b. Clearing Information

The ootions exchanges also create clearing information from the
order and transaction tickets that brokers and marketmakers prepare
on the tradinq floor. On the CBOE*, AMEX, and MSE, floor members usually
submit these tickets to the firms that are going to clear the trades,
and the firms enter the information into their computer systems. 13/
Each clearing firm's trades are then submitted to the exchange where
they took place for purooses of matching and transmittal to OCC for
clearance. On the PSE and PHLX, brokers and marketmakers submit their
tickets to an exchange employee who compares the information that
thev contain. Trades with terms that match are entered into the exchange
computers and sent to OCC. As a result, each options exchange is able
to produce a comouterized report of all the trades that it submits
to OCC.

The CBOE's trade matching and comparison report can be used to
illustrate the information that most options exchange comparison reports
contain. This report is known as a Matched Transaction Listing ("MTL"). 14/
The MTL identifies the two firms that will clear the trade, the brokers
that executed the trade, whether the trade is to clear in a customer,

13/ Appendix Exhibit 1 at p. 26, n.2 describes a different method of
generating clearing information.

14/ An example of an MTL is provided as Exhibit 4.

213

marketnnaker , or firm proprietary account, whether the transaction was

openinq or closinq, the option class and series beinq traded, the number

of contracts traded, and the price to which the parties have aqreed.

If the clear inq firm that will actually clear the trade is not a member

of the exchanqe on which the trade was executed, this firm will be identified

as the "qive-up" firm. AMEX comparison reports contain all of this information

exceot for an identification of the brokers who executed the trade.

This information is not entered into the AMEX clearing process.

Trades that are matched or submitted late are added to the comparison
reports as they are received. Errors and omissions that may occur in
the clear inq process may be corrected by means of position adjustments.
On a dailv basis OCC also provides each options exchange with a computer
tape containinq complete information regarding each transaction that
exchanqe members cleared or adjusted on the previous day. Information
with respect to options positions that were exercised or assigned
is included.

Clear inq information at the NYSE does not contain as much data
as at the options exchanges. The NYSE Reconciliation Clearance Sheets
("NYSE Clear ino Sheets") display only the price and volume of each
transaction and the firms that cleared the trade. 15/ No account infor-
mation is contained because the stock clearing corporations do not

15/ An example of NYSE Reconciliation Clearance Sheets is provided
in Exhibit 5.

214

maintain separate customer, marketmaker, or firm proprietary accounts
for their members as at OCC. The brokers who executed a trade
are not indicated on the stock clearing sheets because this information
is never entered into the clearance process.

c. Account Information

Transaction and clearing information provides an essentially complete
picture of reported marketmaker option trades and positions. In addition,
Daily Position Reoorts that the OCC produces contain, for each account
carried at OCC, the current positions in the account for all option
series, the positions in the account on the previous day, and the
transactions which were cleared since the previous trading session. 16/

With respect to marketmaker stock activities, the AHEX and PHLX
obtain reoorts of all marketmaker stock orders, trades, and positions
on a daily basis. At these exchanges, specialists and ROTs report
this information on forms that the exchanges provide. AMEX Form 958-C
is typical of these forms. 17/ It identifies the specialist or ROT,
his clearing agent, the time that the specialist or ROT reported that
he transmitted each stock order from the AMEX floor for execution,
the type and terms of the order , the number of shares to be bought
or sold, the price and volume of any executions, and the specialist's
or POT's position in the stock at the opening of trading. The form

16/ An OCC Dailv Position Report is shown as Exhibit 6.

17/ An example of AMEX Form 958-C is contained in Exhibit 7.

215

does not contain information concerning the time that all or part
of the order was axecuted or the time that a report of execution was
received.

At the PSE, the marketmaker clearing firms provide similar infor-
mation dailv. PSE Form OTR-1 is used for this purpose. 18/ This form
identifies, bv stock, the time, amount, and limit for each order that
a marketmaker entered, the time and place that the order was executed,
the number of shares that a marketmaker bought or sold during the
dav, end the or ice that he paid or received. The time that the order
was entered is the time that the marketmaker sent the stock order from the
PSE floor for execution, and the time of execution is the time that
an execution reoort was received. Stock position information is not
entered on the form. At the CBOE and MSE, clearing firms provide
dailv reoorts of marketmaker stock trades. These exchanges, however,
obtain marketmaker stock position and unexecuted order information
onlv on a reouest basis.

As a aeneral matter, the time that marketmaker stock orders are
transmitted for execution, the terms of the order, and the time, price,
and volume of any oart of the order that is executed can be obtained
from stock order tickets that the marketmaker 's clearing firm maintains.
Since marketmakers usually enter their stock orders through the firm
that clears their option trades, this firm is generally able to provide

18/ Exhibit 8 is an examole of Form OTR-1.

216

action, and order information. If a market-
er does not enter a stock order throuah the firrr. that clears his

tions at a firm other than his
-iearinq firm, it is oucti -x>re difficult, and may be impossible,
to oc~ er stock activity information.

resoect to customer accounts, the CBOE, AWEX, PSE, PHLX, and
- ~eir members to reoort aggregate long or short positions
of individual customers exceeding 100 contracts in any option class,

in such positions. This reporting requirement
-•ecause OCC maintains only one aggregate account for all
-ion activity at each clearing firm. Such reports, however,
do not disolav customer account trading activity in options, and also
do not >sitions or trading activity in the under -

lvinq ~?ck. Customer account option trading information can presently

c .-^5 only by sending a general request for such information to

Eirn that cleared the customer's options transactions and to the
brokeraqe Eire that e-.tered the customer's options order. Similarly,

r----:: stock tredina information is required z ".ange for

surveillc seSj it mast be obtained by making a general request,

: = , of clearing firms that were active in the stocK
nforaation identifying the accounts that engaged in the stocK trading

217

Members of each options exchange must also file reports with exchanges
if their ootions positions in Droprietary accounts exceed the reporting
thresholds. Their options trading can also be monitored by using
the transaction and clearing information that is normally available.
Because firm proprietary ootions trades reported as such are always
keot in a seoarate account at the OCC and are identified on option
order tickets, they are readily distinguishable in routine surveillance
reports which record this information. If a member firm clears proprietary
ootion orders throuih another firm as a customer, however, resulting
trades would be shown in the customer account of the firm that executed
the orders and not in the oroprietary account of the firm that entered
the orders.

Firm oroorietary stock tradinq, on the other hand, can not generally
be distimuished from customer and marketmaker stock trades on stock
order tickets or in the stock clearing process. This is because the
stock clear inq corporations do not maintain separate accounts for firm
oroorietary stock oositions and because the stock exchanges have not
reouired that order tickets indicate whether a trade is being done
on a orincioal or agency basis. As with customer trading, information
concerninq whether stock trades indicated in the clearing sheets were
effected for a firm proprietary account can only be obtained by making
a reouest of the clear inq firm, on a case-by-case basis, to identify
the party for whom the firm cleared the trade. In addition, firm
oroorietary stock trades that are cleared through another firm in a
customer account are not likely to be discovered by means of a request
sent to the firm that initiated the trades.

Table 2 contains a summary of the transaction and clearing information
that each options exchange captures on a routine basis. The transaction
and clear ina information that the AMEX and NYSE capture with regard to
stock trading is included for comparative Durooses.

218

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219

3. Conclusions and Recommendations

a. Surveillance Information

An effective market surveillance system must be able to
oroduce essential trading information quickly and accurately. It must
be able to identify the brokers participating in each trade, the firms
clearina the trade, the time that the trade occurred, the price
to which the parties have aqreed, the number of shares or contracts
bouaht and sold, and whether the trade was executed for a customer,
firm, or marketmaker account. Ultimately, the system must be able
to identifv, where aporopriate, the customer that effected a transaction.
In addition, the system must be able to identify Pids, offers, and
orders that were oresent in the tradinq crowd to obtain a complete
oicture of the tradinq environment at a particular time. IP the extent
that this information is readily available, the ease of performing
surveillance functions and designing surveillance programs is increased.
Indeed., without such information, it may not be possible for a self-
requlatory organization to ccmoLy with its statutory obligations.

A surveillance system must also provide its user with a physical
record of the trading that the system monitors. Such a record, often referred
to as an audit trail, is necessary to verify the information that the
svstem oroduces. In particular, documentary evidence must be maintained
if totentiallv imrroper trading practices that the system detects are
to be successfully investigated and resolved.

220

(1) AMEX Surveillance Information and Audit Trail

Each of the exchanqes that permits the trading of standardized
ootions has some ability to identify the parties, reporting time, and
terms of trades that take place on its trading floor. In addition,
each of these exchanges has some ability to obtain a physical record of
those trades. The extent of these abilities, however, varies significantly.

The CBOE, PSE, MSE, and PHLX can identify the buying and selling
brokers, the firms that will clear the trade, the time that the transaction
was entered into the or ice retorting system, the price, the number
of contracts for each trade, and whether the trade was executed for a
customer, firm or marketmaker account. Tnis information is available
the dav after the trades occur. It is customarily obtained from order
and transaction reporting tickets that these exchanges collect when
trades are executed and is key punched into exchange computers from
the tradinq floor. The order and transaction reporting tickets are
keot in case they are needed for surveillance purposes at some later
date.

The AMEX, on the other hand, does not maintain as complete a record of
each trade that occurs on its floor. As a result, it can not verify trade
information by usinq its own records. Moreover, the AMEX can not identify,
on a reqular, automated basis, the brokers that execute each trade or
the firms that will clear the trade. Consequently, the AMEX must resort
to the slow and costly process of manually reconstructing trading from
specialist and ROT reports and from order tickets obtained from member firms

221

to detect and investigate questionable trading practices that may take place

on its floor. The need to use manual processes to reconstruct trading

makes it at best costly and time consuming, and at worst impossible,

for the AMEX to Derform many of the surveillance procedures that the

other options exchanges oerform routinely.

The AMEX has recognized that its surveillance system does not routinely

provide information that is essential to an effective detection program.

It has also recognized that a computer could perform more efficiently and more

completely many of the functions that are now done manually. Moreover,

its recent inability to conduct a conclusive investigation into a series of

possible fictitious trades at one options post on its floor has caused

the AMEX to conclude that it must install a complete audit trail to

be able to monitor its market effectively. In this regard, the AMEX

has stated:

Beginning in late September 1978, a pilot test
of a new trade reporting procedure for options con-
tracts will be conducted during trading hours on the
Floor of the Exchange. This test is being undertaken
to examine new procedures related to the capture and
reporting of trade information and to establish an
exoanded data base of trade information for surveillance
Durooses.

Initially, the pilot test will be conducted at one
post at which a number of moderately active options are
traded. As experience is gained, as members become
more acclimated to the new procedure, and if the test
proves successful, it will be expanded during the first

40-940 O - 79 - 17

222

ouarter of 1979 to include the entire options trading
Floor. 19/

The AMEX "pilot test" beqan on October 2, 1978. The AMEX is
now studying the results and cautiously expanding and modifying
the experiment. These constructive efforts to improve AMEX surveillance
capabilities and to create an adecruate audit trail for options transactions
that take place on the AMEX floor should continue expeditiously.

Accordingly, the Options Study recommends:

TOE AMEX SHOULD ESTABLISH A COMFLETE AUDIT
TRAIL FOR EACH OPTION TRANSACTION THAT
TAKES PLACE ON THE AMEX FLOOR IN ACCORDANCE
WITH THE SCHEDULE THAT THE EXCHANGE PRESENTED.
TOF COMMISSION SHOULD REQUIRE THAT TOE AMEX
SUBMIT A COMPLETE REPORT ON THE RESULTS OF
ITS "PILOT TEST" AS SOON AS THEY ARE AVAILABLE.
THE DIVISION OF MARKET REGULATION SHOULD
FOLLOW TOE PROGRESS OF TOE .AMEX CLOSELY TO
ASSURE THAT THE EXCHANGE ENHANCES THE
CAPABILITIES OF ITS SURVEILLANCE SYSTD4
AND ESTABLISHES A PROPER AUDIT TRAIL AS
QUICKLY AS POSSIBLE. THE DIVISION SHOULD
PRESENT A STATUS REPORT ON THE PROGRESS OF
THE AMEX INITIATIVES TO THE COMMISSION
WITHIN 180 DAYS.

IN ADDITION, EACH SELF-REGULATORY ORGANI-
ZATION SHOULD CONSIDER THE FEASIBILITY OF
IDENTIFYING THE ACTUAL TIME THAT A TRADE IS
EXECUTED TO SUPPLEMENT SURVEILLANCE INFORMATION
THAT IS CURRENTLY CAPTURED.

19/ letter to Richard Teberg, Director, Special Study of the Options
Markets, and Richard Weingarten, Special Counsel, from Robert
Birnbaum, President, American Stock Exchange, dated August 29, 1978.

223

(2) NYSE Surveillance Information and Audit Trail

The NYSE is the primary market for virtually all stocks on which
standardized options are traded. As a result, related stock and options
trading that may be improper often involves stock trading on the NYSE.
NYSE's ability to obtain essential surveillance information quickly and
accurately is thus critical to the ability of all the self-regulatory
organizations to obtain a complete picture, and to conduct effective
surveillance, of the trading of options market participants.

In July, 1963, the Report of the Special Study of Securities Markets

recommended that the NYSE evaluate its plans to modernize and automate

its trading floor procedures "with the view to obtaining and preserving

more market data at the time orders are executed than is presently the

case." 20/ Seeking to implement this recommendation, members of the Commission

staff met with representatives of the NYSE on October 31, 1963 to discuss

"the NYSE's projected system of automation." 21/ On December 10, 1963,

the Commission sent the NYSE a letter summarizing the results of the October

31 meeting and urging the exchange to design and implement, as it proceeded

with its modernization plans, an automated market surveillance system

with a complete audit trail. The Commission stated:

The purpose of the [October 31] meeting was to express the
Commission's interest in obtaining transaction data which might
be accumulated within the capacity of the Exchange's program

20/ Report of Special Study of Securities Markets of the Securities
and Exchange Commission, Part 2, at 358 (1963) (the "Special
Study" ) .

21/ Letter to G. Keith Funs ton, President, New York Stock Exchange,
from Ralph Saul, Director, Division of Trading and Markets, dated
December 10, 1963.

224

and equipment. However, it wouid appear that the present plans
of the Exchange for automation do not now provide for the input
of such data. As a result, the following important market data
with respect to each transaction are apparently not to be obtained:

a. Identity of underlying brokers on both sides (that is,
those whose phone clerks received the orders at the edge
of the floor);

b. Whether the sale was long, short or short-exempt;

c. Whether the specialist acted as agent; and

d. Whether the principal was a specialist, floor trader,
odd-lot dealer, or member-off -floor.

Other desirable data not to be obtained are:

e. Executing brokers (if different from underlying);

f. Covering purchases; and

g. Type of order.

An automated system which accumulated sane of all of the
market data outlined above at the point of execution would . . .
assist in important surveillance purposes, perhaps obviating
or mitigating some of the trading problems which have traditionally
occupied the energies of the Exchange and the Commission. Such
a system could furnish immediately, for particular stocks, reliable
and vital data as to prices, volume and market participants.
Development of such a system affords a possibility for less
restrictive rules than might otherwise be necessary.

We are sure that you also appreciate the contribution which
automated equipment can make to the fulfillment of our mutual
regulatory responsibilities. It is difficult to find any
significant reason for not utilizing this equipment to take
full advantage of its potential for these purposes.

In view of the statutory responsibility of both the Exchange
and the Commission, we urge you to take steps to facilitate obtaining

225

the first 4 items listed above and, if practical, the last 3 as
well. We believe that time is an important factor in the program
and, as requested at tne meeting on October 31, we would appreciate
your specific advice on each of these items at the earliest
possible date. 22/

On December 17, 1963, the NYSE responded. The exchange simply stated
that its "present automation program has not contemplated the capturing of
the additional information detailed in [the Commission's] letter." 23/
The exchange agreed, however, to keep "an open mind concerning the
development of additional systems for the future and . . . welcome [d]
the chance to discuss the problems involved with [the Commission
and the staff]." 24/

The Senate Securities Industry Study of 1973 accurately summarized

the course of events that followed:

For the next three years the SEC continued to urge
and the NYSE continued to resist the prompt development
of an automated . . . surveillance system. Finally in
1966 tne SEC wrote to the NYSE: "We do not believe
that the Exchange, without obtaining such [transaction]
information, can fulfill its self-regulatory responsi-
bilities . . . ." 25/ The NYSE did not respond specifically

22/ Id.

23/ Letter to Ralph S. Saul, Director, Division of Trading and Markets,
from G. Keith Funs ton, President, New York Stock Exchange, dated
December 17, 1963.

24/ Id.

25/ Letter to John R. Bermingham, New York Stock Exchange,

from Irving M. Pollack, Director, Division of Trading and Markets,
dated June 30, 1966.

226

a. Identity of underlying brokers on both sides (that is,
those whose phone clerks received the orders at the edge
of the floor ) ;

b. Whether the sale was long, short or short-exempt;

c. Whether the specialist acted as agent; and

d. Whether the principal was a specialist, floor trader,
odd-lot dealer , or member-of f- floor .

Other desirable data not to be obtained are:

e. Executing brokers (if different from underlying);

f. Cover inq purchases; and
q. Type of order.

An automated system which accumulated some of all of the
market data outlined above at the point of execution would . . .
assist in important surveillance purposes, perhaps obviating
or mitinating some of the trading problems vrtiich have traditionally
occupied the energies of the Exchange and the Commission. Such
a svstem could furnish immediately, for particular stocks, reliable
and vital data as to prices, volume and market participants.
Development of such a system affords a possibility for less
restrictive rules than might otherwise be necessary.

We are sure that you also appreciate the contribution which
automated equipment can make to the fulfillment of our mutual
requlatory responsibilities. It is difficult to find any
sionificant reason for not utilizinq this equipment to take
full advantaqe of its potential for these purposes.

In view of the statutory responsibility of both the Exchange
and the Commission, we urge you to take steps to facilitate obtaining
the first 4 items listed above and, if practical, the last 3 as
well. We believe that time is an important factor in the program

227

and, as reouested at the meeting on October 31, we would appreciate
your soecific advice on each of these items at the earliest
possible date. 22/

Ch December 17, 1963, the NYSE responded. The exchange simply stated
that its "present automation orogram has not contemplated the capturing of
the additional information detailed in [the Commission's] letter." 23/
The exchanqe aqreed, however, to keeD "an open mind concerning the
development of additional systems for the future and . . . welcome [d]
the chance to discuss the problems involved with [the Commission
and the staff 1 ." 24/

The Senate Securities Industry Study of 1973 accurately summarized

the course of events that followed:

For the next three years the SEC continued to urge
and the NYSE continued to resist the prompt development
of an automated . . . surveillance system. Finally in
1966 the SEC wrote to the NYSE: "We do not believe
that the Exchanqe, without obtaining such [transaction]
information, can fulfill its self-regulatory responsi-
bilities . . . ." 25/ The NYSE did not respond specifically

22/ Id.

23/ Letter to Raloh S. Saul, Director, Division of Trading and Markets,
from G. Keith Funston, President, New York Stock Exchange, dated
December 17, 1963.

24/ Id.

25/ Letter to John R. Bermingham, New York Stock Exchange,

from Irvinq M. Pollack, Director, Division of Trading and Markets,
dated June 30, 1966.

228

to this assertion but stated once aqain: "The exchange
would maintain an open mind as to the development of
additional svstems which may be able to capture such
information." 26/

The SEC continued to raise the issue of automating . . .
surveillance with the NYSE during 1967. The NYSE indicated
that it had nade no progress in this area but that it would
keen the SEC informed on the status of its automation programs. 27/
The matter appears to have been dropped at that point. 28/

Althouqh more than 15 years 'have passed since the Special Study

made its recommendations, the NYSE has not yet implemented an automated

market surveillance svstem or an adequate audit trail. The exchange

still does not have the ability to identify, on a routine, automated

basis, the oarticioants in each trade on its floor. Nor does the

exchanqe vet maintain a record, collected at the time that orders are

executed, which indicates the parties, the execution or reporting

tine, and the terms of each trade. While the Options Study has not

examined or analvzed the NYSE surveillance system as a whole, the

lack of such essential surveillance information raises a substantial

concern, as the Commission suggested in 1963 and in 1966, regarding

26/ Letter to Irvina M. Pollack, Director, Division of Trading and
Markets, from John R. Bermingham, New York Stock Exchange,
dated Auqust 8, 1966.

27/ SFC Memorandum of Conference between NYSE and SEC Officials, dated
June 19, 1967.

28/ Reoort of the Subcommittee on Securities of the Committee on Banking
Housing and Urban Affairs, Securities Industry Study, 93d Cong.,
1st Sess. 184 (1973).

229

whether the exchame has the ability to fulfill its statutory responsi-
bilities on a daily basis for each stock that is traded on the NYSE
floor. Moreover, desoite the NYSE's recent initiation of a multimillion
dollar "tradinq facilities uoqrade project," the exchange has not
indicated any intention of reqularly obtaining the surveillance information
that it lacks. 29/ In fact, on October 16, 1978, the NYSE stated:

While we are always looking to improve our surveillance
capabilities, it may not be feasible to try to enhance
audit trail capabilities at the point of execution in
the short term, as this may be disruptive to the
execution nrocess with the systems that exist today
since it would reouire adding reporting staff to the
Floor, or burdening reporters with additional
responsibilities. 30/

Accordinglv, the Options Study recommends:

WE COMMISSION SHOULD CONDUCT A COMPLETE INSPECTION
OF THE NYSE MARKET SURVEILLANCE SYSTEM TO DETERMINE
WHETHER THF EXCHANGE HAS THE ABILITY TO CARRY OUT
THE PURPOSES OF THE ACT AND TO COMPLY AND ENFORCE
COMPLIANCE BY ITS MEMBERS WITH THE ACT, THE RULES AND
REGULATIONS THEREUNDER, AND NYSE RULES. SPECIFICALLY,
THF INSPECTION SHOULD CONSIDER WHETHER THE NYSE
CAN DETECT, ON A DAILY BASIS AND FOR EACH STOCK
TRADED ON THE NYSE, TRADING PRACTICES THAT MAY BE
INCONSISTENT WITH THE ACT, THE RULES AND REGULATIONS
THEREUNDER, OR EXCHANGE RULES. THE INSPECTION SHOULD
BE CONDUCTED AND COMPLETED AS EXPEDITIOUSLY AS POSSIBLE
AND A COMPLETE REPORT SHOULD BE PRESENTED TO THE
COMMISSION WITHIN SIXTY DAYS AFTER THE COMPLETION
OF THF REVIEW.

29/ Letter to Harold M. Williams, Chairman, Securities and Exchange
Commission, from William M. Batten, Chairman, New York Stock
Exchanqe, dated October 16, 1978.

30/ Id.

230

IN THE EVENT THAT THE INSPECTION REVEALS THAT THE NYSE
CANNOT FULFILL ITS STATUTORY RESPONSIBILITIES ON A
DAILY BASIS, THE COMMISSION SHOULD TAKE APPROPRIATE
REMEDIAL STEPS AND SHOULD SPECIFICALLY CONSIDER REQUIRING,
BY COMMISSION RULE, THAT THE EXCHANGE COLLECT AND
MAINTAIN ESSENTIAL SURVEILLANCE INFORMATION.

(3) Stock Market Reconstruction

Market reconstruction is the orocess of identifying the parties
to a series of transactions, the time and sequence of the transactions,
and the or ice and number of shares or contracts involved. It may
also involve the identification of the buying and selling interest
in a security at a particular time. The purpose of a reconstruction
is usuallv to determine the effect that particular transactions
or orders miaht have had on the market for the security being analyzed.

The NYSE has stock trading information at its disposal for
conducting stock market reconstructions that exceeds the information
available to anv other self-regulatory organization. Using its Daily
Transaction Journal, specialist and registered marketmaker and trader
transaction reports, sheets from the specialist's limit order book,
confirmation stubs, dailv clearing sheets, ITS and DOT Journals,
and order tickets obtained from member firms, the NYSE can usually
identify the brokers, dealers, and clearing firms who participate
in a particular trade, the time that orders enter and leave the floor,
the time that trades are entered into the price reporting system,
and the price and volume of each transaction. Some of these information

231

sources also contain information concerninq stock orders that were
oresent on the tradinq floor but that were not executed during a particular
tradinq session. The NYSE reconstruction process, however , is still largely
manual and, as a result, -is costly and time consuming. In addition, the
absence of an audit trail at the NYSE may make it difficult, if not
impossible, to investigate ootentially imtxoper trading practices in
particular cases because the exchange may be unable to determine
definitively the oarties to transactions that may be under consideration.

To help reconstruct option marketmaker stock trading, each options
exchanqe obtains reports of the stock transactions of its marketmakers
on a dailv basis. The CBOE, MSE, and PSE obtain this information from
the firms that clear their marketmakers1 trades, and the AMEX and
PHLX relv primarily upon stock activity reports that they require
their specialists and RCTs to file. Using this information and obtaining
order tickets from the clearing firms if necessary, each options exchange
is able to determine the time that each marketmaker stock order was
transmitted for execution, the amount of the order and its type, the
time that it was reported as executed and the number of shares bought
or sold. With this information and the NYSE Fitch Sheets, which
are oubliclv available and contain the time that trades of stocks listed
on the NYSE were entered into the price reporting system, the price,
and volume for each transaction in a stock in any market, the options

232

exchanges may be able to estimate the impact that a marketmaker ' s stock
orders and transactions may have had upon a stock. Viewing this information
in conjunction with their records of options trading and positions,
the options exchanges can generally conduct effective inquiries and
investigations into related activity in stock and options by their market-
makers. Of course, if marketmakers do not clear their stock trades
or carry their stock positions with the firm that clears their options
trades, or if specialists and ROTs do not report their stock trades,
it is more difficult, and may be impossible, for the exchanges to detect
related stock and option trading by marketmakers that might be inconsistent
with the Act or exchange rules. Improvements should be made to assure
that such marketmakers can not evade self -regulatory organization surveil-
lance systems by clearing stock trades or carrying stock positions at
firms other than their option clearing firms.
Accordingly, the Options Study recommends:

THE COMMISSION SHOULD REQUIRE THAT ALL SELF-REGULATORY
ORGANIZATIONS ADOPT RULES REQUIRING ALL REGISTERED
OPTIONS MARKETMAKERS TO REPORT, BY APPROPRIATE MEANS
AND ON A DAILY BASIS: (1) THE TIME THAT EACH STOCK
ORDER FOR THE MARKETMAKER ' S ACCOUNT, OR AN ACCOUNT IN
WHICH HE HAS AN INTEREST, IS TRANSMITTED FOR EXECUTION,
(2) THE TYPE AND TERMS OF EACH ORDER, (3) THE TIME, VOLUME,
AND PRICE OF ANY EXECUTIONS THAT ARE RECEIVED, AND (4) THE
OPENING AND CLOSING STOCK POSITIONS FOR EACH ACCOUNT IN
WHICH THE MARKETMAKER HAS AN INTEREST.

233

THE COMMISSION SHOULD ALSO (1) REQUIRE THAT THE SELF-REGULATORY
ORGANIZATIONS ADOPT RULES REQUIRING ALL REGISTERED MARKET-
MAKERS TO REPORT ALL ACCOUNTS, FOR STOCK AND OPTION TRADING,
IN WHICH THEY HAVE AN INTEREST OR THROUGH WHICH THEY MAY '
ENGAGE IN TRADING ACTIVITIES, AND (2) PROHIBIT MARKETMAKER
TRADING THROUGH ACCOUI7TS OTHER THAN THOSE REPORTED.

(4) Firm Proprietary and Customer Trading Identification

While each of the ootions exchanges has developed methods of routinely
obtaining substantial information concerning the stock and options
activities of their marketmakers, information about related stock
and options trading of customers and the proprietary accounts of member
firms is not readilv available for routine surveillance purposes.
OCC, for example, maintains separate accounts for marketmaker, firm
oroorietarv, and customer options trading. The stock clearing corporations
do not distinguish among such accounts when clearing stock transactions.
In other words, the stock clearing corporations keep one account for
each clear inq firm, and the task of allocating cleared trades among
the various types of accounts is left to the firms. As a result, the
stock clearing sheets that are used to determine who has been active
in a stock reveal onlv the firms that cleared trades and not the accounts,
nor the tyoes of accounts, for which the trades were cleared.

This method of clearing stock transactions makes it necessary
for the options exchanges to send an inouiry to the firms that cleared

234

stock traces each time that it appears that these trades may be related
to options activity. Frequently, however, the options exchanges only
need information concerning the trading of a firm's proprietary account.
In a front-runninq , minimanipulation, capping, or pegging inquiry,
for example, an exchange may know, due to the account information
orovided by OCC, that option trades were done in a firm's proprietary
account and may wish to find out whether the same firm engaged in stock
activity for its own account. A review of the stock clearing sheets
mav show that the firm cleared stock trades that might have some relation-
shio to the option trades, but will not tell the analyst whether the
stock transactions were cleared for the firm's account, for one customer,
or for manv customers. Consequently, a letter of inquiry must be
sent to the firm askim it to identify the accounts that participated
in the stock trades. This process is costly and time consuming for
the options exchanqes and for member firms and does not routinely
provide the exchannes with member firm proprietary stock trading
information ccmoarable to that which is independently obtained for
marketmakers.

The NYSE and SIAC have recently undertaken to determine the
feasibilitv and cost of distinguishing between member firm proprietary
and customer trades in the clearing process. The Options Study has been

235

informed that SIAC is initiatinq a study of this question and that

a report should be available by March 31, 1979. 31/

Accord inqlv, the Options Study recommends:

THE COMMISSION SHOULD REVIEW TOE SIAC REPORT

AS SOON AS IT IS COMPLETED. THE SELF-REGULATORY

ORGANIZATIONS AND THEIR MEMBER FIRMS SHOULD WORK

TO ESTABLISH AN ECONOMICAL METHOD FOR IDENTIFYING

AND DISTINGUISHING MEMBER FIRM PROPRIETARY AND CUSTOMER

STOCK ORDERS AND TRANSACTIONS. IN THE EVENT THAT

THE SELF-REGULATORY ORGANIZATIONS DO NOT DEVISE A

METHOD FOR EASILY IDENTIFYING MEMBER FIRM PROPRIETARY

.AND CUSTOMER TRADING, THE COMMISSION SHOULD CONSIDER

WHETHER IT IS APPROPRIATE TO REQUIRE THAT THEY DO

SO BY COMMISSION RULE.

The reqular availability of information distinquishinq member firm

proorietarv and customer stock tradinq should enhance the ability

of the options exchanqes to monitor related stock and options tradinq

by firm oronrietary accounts. It may also result in cost and time

savings for exchanqes and their members. Further, creatinq a system

that will distinguish between principal and aqency orders and trades

will facilitate comoliance with Section 11(a) of the Act and assure

that self-requlatory oraanizations have the ability to detect

ootential violations of that section. 32/

31/ Letter to Richard Teberq , Director, Special Study of the Options
Markets, from Robert M. Bishoo, Senior Vice-President, New York
Stock Exchanqe, dated September 28, 1978.

32/ See Securities Exchanqe Act Release No. 12055 (January 27, 1976).

Securities Exchanqe Act Release No. 13388 (March 18, 1977); Securities
Exchanqe Act Release No. 14563 (March 14, 1978); Securities Exchange
Act Release No. 14713 (April 27, 1978); and Securities Exchanqe Act
Release No. 14795 (May 24, 1978).

236

(5) Customer Account Identification

Neither OCC nor the stock clearing corporations presently
maintains a record of specific customers for whom stock and options
trades are executed. At OCC, each clearing firm conducting a public
business has a customer account in which all customer options transactions
are cleared, and at the stock clearing corporations all stock transactions
for each firm are cleared in one account. To identify the customers
for whom particular trades were effected, an exchange must ask the clearing
firms which customers effected the trades and must await a response. This
orocess is costly and time consuming for the exchanges and for the member
firms. In addition, firm responses may recruire further inquiries
of other broker-dealers and may not result in a complete picture of
a customer's trading. If a clearing firm clears for another broker-
dealer, for example, the clearing firm may respond to an inquiry asking
about customer trading by providing the name of the broker-dealer
for whom it is clearing. It would then be necessary to send an inquiry
to that broker-dealer to determine the identity of its customer. Moreover,
the response of one broker to a request for information about a customer's
tradinq will not reveal transactions that the customer may have effected
throuqh other brokers and other accounts. Consequently, it may be
extremelv difficult, if not impossible, to detect improper trading practices
or violations of self-regulatory organization rules in which a customer
may engage if the customer trades through separate accounts at multiple
brokers.

237

The Options Study recognizes that customer account information is
maintained in numerous forms at member firms. The Options Study is also
aware that the cost and time that would be necessary to design and implement
a system that would establish a uniform method of identifying customers
and would make complete customer information available for surveillance
ourooses on a routine, automated basis may be substantial.

The availability of customer account information on an automated,
routine basis, however, would substantially improve the ability of the
self-regulatory organizations to detect customer trading that may be
inconsistent with the Act or their rules. Tne time and money that the
self-regulatory organizations and their members expend making and
responding to inouiries about customer trading could be significantly
reduced if the self-regulators were able to determine easily the customer
for whom a trade was executed. A large brokerage firm, for example, may
respond to freauent requests from options exchanges about legitimate
customer trading simply because its customer account at OCC has cleared
trades that might be improper if done by one customer or a group of
customers in concert. Usually, however, the exchanges find that numerous
unrelated customers engaged in the trades. Such inquiries would not
be necessary if an exchange were able to readily ascertain how many
and which customers effected the transactions.

40-940 O - 79 - 11

238

As self-requlatorv orqanizations modernize their trading facilities
and firms modernize their order routing and processing systems, it may
become easier to create a standard format for identifying customers
and obtaininq customer account information for surveillance purposes.
The NYSF and SIAC are currently studying the feasibility and cost of
caoturino customer information in the clearing process, and a full
report is exDected by March 31, 1979. 33/

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD BEGIN TO STUDY THE MOST
APPROPRIATE MEANS OF ESTABLISHING A UNIFORM
METHOD OF IDENTIFYING STOCK AND OPTION CUSTOMERS
ON A ROUTINE, AUTOMATED BASIS. THE COMMISSION
SHOULD REVIEW THE NYSE AND SIAC REPORT ON THIS
SUBJECT AND SHOULD DETERMINE THE STEPS THAT
SHOULD BE TAKEN TO ESTABLISH A UNIFORM ACCOUNT
IDENTIFICATION SYSTEM IN LIGHT OF THE REPORT.

(6) OCC Position Adjustments

Durinq the trade match and comparison processes at the
options exchanaes, errors and omissions may occur when the terms and
oarties to a trade are entered into the computers of the clearing
firms for clearing purposes. To correct these errors and amissions,
clearing members submit position adjustments to the OCC. The adjustments

33/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from Robert M. Eishop, Senior Vice-President, New York
Stock Exchanqe, dated September 28, 1978.

239

are submitted in the form of purchases and sales and must be matched.
In other words, for every purchase there must be a corresponding sale.
Position adjustments may also occur between two clearing firms if
a customer or marketmaker account is transferred from one firm to
another or if one firm executes and compares trades for another firm
on an exchange of which the first firm is not a member. These
adjustments are referred to as transfer of account and Clearing Member
Trade Agreement ("CMTA") adjustments.

Position adjustments, however, may also be used for improper
DurDoses. Trade reversals, openinq transactions by customers in
restricted ootions, avoidance of the public priority rules, and off-floor
trad inn ^ay be accomDlished by means of such adjustments. An effective
options surveillance system must therefore contain sufficient information
to Permit a self-reoulatory organization to detect position adjustments
that mav have been entered for improper purposes.

At oresent, OCC issues a report each day containing the adjust-
ments that each clear inq firm submits. The report does not identify
the purpose of the adjustment or relate the adjustment to a particular
trade. In fact, OCC does not reouire its members to indicate the
purpose of particular adjustments, and it is difficult to trace some
adjustments to trades because many firms do not reconcile their books
to OCC records on a dailv basis. Instead, they may balance their positions
less freouently and submit one set of adjustments to correct any
discrepancies.

240

The Options Study's inspections revealed varying degrees of
sophistication among the options exchanges with respect to the review
of position adiustments. At the CBOE and PSE, for example, certain
types of adiustments with well-defined characteristics are reviewed.
At the AMEX, on the other hand, Questionnaires are sent on an essentially
random basis to firms that enter large adjustments. These questionnaires
ask the reasons that the adjustments were made. At the PHLX and MSE,
the extent to which position adjustments are reviewed, understood,
and monitored was not apparent. The inspections also demonstrated
that firms are routinelv able to trace most adjustments back to particular
trades when asked and that order tickets containing the errors that
caused the adjustments can generally be provided if requested.

OCC, however, intends to revise its adjustment procedures by the

end of the first ouarter of 1979. OCC plans to make three significant

revisions in the adjustment process and describes these as follows:

The first change which would be accomplished . . .
is the implementation of a separate transfer of account
system which would provide an independent audit trail
for transfers of account as opposed to other types
of adjustments. Under the new transfer of account
system, two sided input will be required. Both the
transferor clearing firm and the transferee clearing
firm must submit documentation to OCC on authorized
Transfer of Account Forms .... No transfer will
be permitted to go through the system unless both
the transferor and the transferee firm agree to
the transfer.

In addition, the transfer system would have
such controls so as to make it impossible to trans-
fer a market-maker position at one clearing firm

241

to a different market-maker account at another firm.
In addition, transfers that do not match on the
first day that incut is submitted to OCC will be
Dendinq for a maximum of five business days, allowing
the two Clear inq Members time to reconcile any errors.
At the end of five days, any oending items which
have been transferred would be dropped from the system
and the Clear inq Members would be reouired to submit
new inout to OCC before the transfer of account could
be accomplished .

Ihe revised system would also change the present
CMTA adjustment procedure. . . . No firm would be
able to submit a CMTA adjustment unless they had a
valid CMTA aqreement on file with OCC. The system
would be desiqned so that unless such an agreement
was on file, any such adjustment would be rejected.
... [In addition,] all CMTA adjustment input documents
would require the Clearing Member to designate the
Exchange on which the transaction occurred and the
date on which the transaction occurred.

Finally, the Position Adjustment Form is also
beinq revised so that a position adjustment may be
effected onlv in tra-cl earing firm; that is, only
open-close and account type errors may be corrected
throuqh the revised position adjustment form. . . .
These adjustments would be submitted as a single
line item input so that both the buy and the sell
side of the adjustment could be clearly related.

In addition, the position adjustment system would
be modified so that each potential open-close, buy-sell
situation would be separately coded and identifiable.
Accord inqly, surveillance reports could and will be
developed with the ability to recall for surveillance
purposes each c ltial adjustment combination. This
system shoulc Participant Exchanges to determine

whether potent. questionable practices may be taking
olace. 34/

34/ Letter to Sheldon Rappaport, Deputy Director, Division of Market

Regulation, from Marc L. Berman , Vice-President and General Counsel
of OCC, dated August 2, 1978.

242

The Options Study believes that implementation of these revisions will
siqnif icantly improve the ability of the options exchanges to detect
improprieties that mav be effected by means of the adjustment process.
By distinauishinq transfers of account and CMTA adjustments from other
adjustments, codinq and identifyinq open-close and buy-sell adjustments,
and oroscribinq adjustments between clearing firms, the potential for
abusinq the adjustment process will be reduced substantially. As
importantly, the ability of the options exchanges to understand and
investiqate particular adjustments should be enhanced.

However, more could be done to reduce the number of adjustments that
firms submit to OCC. Since many adjustments are the result of
illeqible handwritinq and clerical errors in entering information into
the clearing process, the number of adjustments may be further reduced
if OCC were to introduce disincentives to the entry of adjustments.
Reductions might also be accomplished, and the ability of firms and
exchanges to relate adjustments to particular trades enhanced, if the OCC
reouired its member firms to reconcile their accounts to OCC accounts on
a daily basis.

Accordingly, the Options Study recommends:

OCC SHOULD IMPLEMENT THE REVISIONS IN
ADJUSTMENT PROCEDURES THAT IT HAS PROPOSED
*S SCHEDULED. OCC SHOULD ALSO CONSIDER THE
FEASIBILITY OF IMPOSING A SURCHARGE FOR
POSITION ADJUSTMENTS THAT FIRMS EFFECT

243

ABOVE A CERTAIN NUMBER OF CONTRACTS. THE NUM3ER
OF ADJUSTMENTS THAT A FIRM SHOULD BE PERMITTED
WITHOUT THE IMPOSITION OF THE CHARGE SHOULD
BE DETERMINED GIVING FULL CONSIDERATION TO
THE NUMBER OF CONTRACTS THAT THE FIRM REGULARLY
CLEARS. IN ADDITION, CCC SHOULD CONSIDER THE
FEASIBILITY OF REQUIRING ITS MEMBER FIRMS TO
BALANCE THEIR RECORDS TO CCC RECORDS ON A DAILY
BASIS. THE COMMISSION SHOULD REQUIRE CCC TO
STUDY THESE ISSUES AND REPORT ITS CONCLUSIONS AND
RECOMMENDATIONS TO THE DIVISION OF MARKET REGULATION
WITHIN 90 DAYS.

b. Surveillance Techniques

Each options exchanqe monitors its market to detect trading practices
that mav be inconsistent with the Act and its own rules. These exchanges
have developed techniques to detect related option and stock trading
that miqht be manipulative , prearranged and fictitious option trading,
misuse of material market and inside information, and violations of
certain other exchange rules. While the best of the techniques that
have been developed would provide a self-regulatory organization with
a general abilitv to detect such trading practices, improvements must
be made to maximize the effectiveness of the self-regulatory organization
market surveillance.

( 1) Surveillance Techniques and Surveillance Information

First, the surveillance information that is available to each self-
regulatorv organization must be made more complete as recommended in

244

the orevious section. This should improve the ability of the self-
requlatorv orqanizations to reconstruct their markets and the activities
of their members more accurately, more quickly, and more economically
than at present. Further, this should enhance the ability of the self-
requlatory orqanizations to perform surveillance functions without requesting
as much information from members as often as is currently the case.

(2) The Sharing of Surveillance Information and the
Allocation of Requlatory Responsibility

Second, the surveillance data that exist at each self-regulatory
oraanization must be made readily and economically available to other
self-reaulatory organizations that may need such data for regulatory
purposes. Because the trading activities of a member are not necessarily
confined to the marketplaces of which he is a member, and because
standardized options tradinq has increased the opportunities for market
participants to enqaqe in related activities in numerous markets, the
importance of data sharinq and integration has increased.

To conduct surveillance of tradinq practices that involve stock
and options, for example, the options exchanges rely heavily upon
transaction snd clear inq information from the New York Stock Exchange.
To monitor the activities of a member in an option that is traded
on more than one exchanqe, transaction and clear inq data from

245

all exchanqes on which the option is listed must be gathered. At
oresent, however, such information is qenerally available only on
a reouest basis. Perhaps most significantly, the self-regulatory
organizations do not always notify each other and share information
concerninq investigations and studies that they are conducting even
thounh such studies and investigations often involve trading that
took place in more than one market and market participants who are
members of more than one self-regulatory organization. Moreover ,
studies and investiqations may be duplicated, at the expense of the
members, merelv because the self-regulatory organizations do not inform
each other routinely of their activities.

The self-requlatory orqanizations have recognized that they can
enhance their surveillance capabilities and save time and money by
sharinn the surveillance information that each of them possesses,
coordinatinq their requlatory efforts, and formalizing the channels
of communication amonq them. In fact, the options exchanges, the
WSE, the NASD, OCC, and the Boston Stock Exchange (the "Self-
Pequlatorv Conference" or the "Conference") have recently begun the
Drocess of integrating their surveillance and other regulatory systems.
Since Auaust, 1978, these self-requlatory organizations have held
a series of meetinqs which "have focused ucon the need for the creation

246

of an integrated reaulatory system among the self -regulatory organi-
zations which would enhance total industry regulatory capability by
coordinating and interfacing existing regulatory data and programs
through the sharing of available information, improvement of regulatory
techniaues, [and] the allocation of regulatory responsibility. . . ." 35/
The ourpose of the meetings has been to "imrrove [the] overall regulatory
capability of the SRO's," and to "eliminate overlapping efforts which
mav oresentlv exist, to fill existing voids in regulatory programs and
to oromote the interchange of and access to information." 36/ Significantly,
the Conference has acknowledqed that "the establishment of a more fully
inteqrated regulatory system is both necessary and desirable as a means
of establishing more efficient and effective regulation which may be
cost-effective to the industry and achieve minimum standards of regulation
on an industrv-wide basis thus assuring the protection of public
investors." 37/

The Conference divided into subgroups for the purpose of focusing
on SDecific issues. Each subgroup presented a report to the Conference,
and the Conference Dresented a report to the Study. Two sections of

35/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self -Regulatory Conference, dated October 6,
1978. A copy of this letter is attached as Exhibit 9.

36/ Id.

37/ Id.

247

the Conference Reoort demonstrate significant progress toward the creation

of an integrated surveillance system for stock and options. These

portions of the reoort, dealing with "Interchange of Market Surveillance

Information" and "Allocation of Responsibility," are ouoted at length to

qive a ccmolete view of the steDS that the Conference has taken and

will take. The report states:

I. Interchange of Information

A sub-qrouo was established on interchange of Market Surveillance
information. This body was directed to identify all market surveil-
lance reports and information presently available to each participant
SRO in order to determine which information could be integrated
into other self -regulatory organizations' programs to enhance
existing regulatory efforts with respect to intermarket surveillance.
This sub-group thereafter collected from and furnished to each
participant SRC, including the Cotions Clearing Corporation,
cooies of all option and equity computer print-outs and certain
manually prepared reports (along with explanatory materials
identifying the type of data, format, frequency and purpose)
which are utilized in conducting market surveillance for listed
securities. In addition to disseminating examples of data
base information derived from transaction and clearing streams,
each organization provided copies of reports which identify
activity which exceeds pre-determined parameters during a
trading session.

^fter the analysis of this voluminous information, a better
understanding of the nature of information available was
achieved. There was also a consensus that the sharing of
data bv the various SRO's is both needed and desired. HDwever ,
while certain agreements have been reached, it is yet to be
determined whether all such information will be furnished
routinely or on some other basis.

It is generally agreed that any information interchanged
may be more desirable in a computer readable format rather
than on microfiche or hard copy print -outs for manageability
and flexibility purposes.

248

Further , it was noted that certain data which would be useful
to each organization is presently available on an on-line
basis throuqh . . . systems . . . for collecting and displaying
option information and for stock activity from the last sale
and ouote information transmitted via hiqh speed lines. This
information could be captured with appropriate programming
which is being developed.

After identifying the information available, the participant
SRO's excressed interest in the exchange of market surveillance
information as follows:

a) Reconciliation Clearing Sheets from markets where
securities underlying options are traded.

b) Daily Transaction Journals from all markets where
securities underlying options are traded.

c) Monthly Short Interest Reports by firm from all
markets where securities underlying options are traded,

d) Block trade reports from all markets where securities
and options are traded.

e) Notification of the initiation of investigations and
reviews, as appropriate.

f) Status reDorts on investigations and reviews, as
aooropr iate .

a) Notification of trading halts.

h) Notification of corporate contacts resulting from

unusual trading activity,
i) Exercise/Assignment Listing Reports from OCC.
i) Open Interest Distribution Reports from OCC.
k) Market Data Retrieval Reports and Matched Trade

Li st inn Reports.

Tne eouity exchanaes indicated that they would be responsive
to inouiries by the options exchanges with respect to matters
which could affect trading in underlying securities and options
trading thereon and would make every effort to inform other
appropriate market centers of trading halts.

249

With respect to the interchange of information pertaining

to multiply listed options, we believe that useful data is

currently being disseminated to the options exchanges via

the dailv Ootions Clearing Corporation compliance tape and

that the modifications due to be implemented in the beginning

of 1979 will enhance monitoring capabilities by providing

member transactions in multiply traded classes on other exchanges.

These modifications, as currently envisioned will consist

of each participant SRO receiving the following:

a) All positions, exercises/assignments and
adjustments of their members regardless of
where the options class is listed;

b) All cleared options transactions of their
mar ketmakers/specialists/ registered traders;
and

c) All exercises, assignments, nositions and adjust-
ments of non-members trading in classes which are
solely listed on their exchange.

There is general agreement among the participant SRO's that they are
willina to share information for surveillance purposes subject
to certain specific limitations, i.e. non-member specialist
and narketmaker positions which would be provided on a case-by-
case basis rather than as a matter of routine. It is important
to note that the participant SRO's agree that all information would
be available to other SRO's for specific investigations.

IV. Allocation of Responsibility

We established an allocation of responsibility sub-group to
exnlore the means of identifying and eliminating duplicative
requlatory efforts as well as the measures necessary to improve
requlatory programs. The sub-group was also requested to provide
the means of resolving such overlaps and shortfalls through
the allocation of responsibility for investigation and
enforcement and to assure, as much as Dossible, the uniform
interpretation and application of comparable self -regulatory

250

and Commission rules. The qroup focused on problems involving
-jurisdictional issues where membership in more than one self-
requlatory organization existed and on inter-market trading
activities which transcended individual SRO jurisdictional
boundaries, such as insider trading activities, fraudulent
and manipulative tradinq practices, tape racing, front-running,
exoiration studies and other specific inter-market transactions.

For ourposes of its discussions, the participants determined that
non-member broker-dealers and non-member broker-dealer customers
would be treated as the same type of entity for surveillance
ourposes. It was also determined that where a non-nember (whether
a broker-dealer or customer ) effects a transaction using the
facilities of a member broker-dealer, the matter should be
referred to the SRO that has jurisdiction over that non-member
or to the SEC if a non-broker -dealer customer is involved.

Of course, the ouestions of jurisdiction over a broker-dealer
which is a member of more than one self-regulatory organization
and/or when a security is multiply traded encompass much
broader and complex issues and consequently consumed a significant
portion of the group's efforts. Based upon its discussions,
the qroup agreed to consider the following principles of
allocation:

(1) The surveillance and regulation of specialists, market-
makers and registered floor traders will be retained by
the self-regulatorv organizations of which they are a
member and on which they fulfill such functions.

(2) The gathering of customer and firm information needed in
oursuinq insider trading and manipulation cases shall

be allocated to the primary market in that family of
markets whenever there is a dually traded security.

(3) Whenever an SRO conducting an investigation lacks jurisdiction
over a broker-dealer non-member, the information necessary

to conduct the investigation shall be obtained from
any other self-regulatory organization of which such non-
member is a member .

(4) Expiration Studies - It was agreed that the SRO's would
inform each other when they are preparing to conduct
expiration studies of options vs. stocks in order to prevent

251

a duplication of effort. If two or more self -regulatory
ornanizations have decided to perform a similar study, they
would determine amonq themselves which would conduct the
study; however , where market-makers, specialists and
reqistered floor traders are involved, the self-regulatory
orqanizations of which they are a member shall retain re-
sponsibility for invest iaatinq such matters.

(5) Disciplinary Procedures - Self-regulatory organizations shall
share information while retaining jurisdiction of their own
members; however, where joint members are involved the market
where the violative activity occurred would be responsible
for disciolining the member unless otherwise agreed upon.

(6) Emplovees of SRO's will be made available for testimony
as needed by other SRD's in any case where their
testimony is reouired or where such employees performed
a nortion of an investigation or examination. (The
self-requletorv orqanizations will continue to review
the possibility of reouiring their members to testify
at disciplinary hearings of other self-regulatory
orqanizations which lack jurisdictional authority over
such members. )

To acccmolish our goals, it is anticipated that there will be
further discussion by the participants to allocate additional
responsibilities with respect to matters arising from the inter-
market requlatory Dr obi ems and to further eliminate regulatory
duplication. 38/

Thus, the self-regulatory organizations appear to be making progress

toward achievinn an effective sharing and integration of information

and coordinatina and allocatinq regulatory responsibilities with respect

38/ Id.

252

to market surveillance. The steps that have been taken help to

assure that, as the Congress envisioned, a "more coherent and rational

regulatory structure" in which there would be "an explicit allocation

of regulatory responsibility" will be established. 39/

Accord inqly, the Options Study recommends:

THE COMMISSION SHOULD CLOSELY MONITOR THE EFFORTS
OF THE SELF-REGULATORY ORGANIZATIONS TO SHARE SURVEILLANCE
INFORMATION AND COORDINATE SELF-REGULATORY ACTIVITIES.
THE COMMISSION SHOULD ACKNOWLEDGE BY LETTER THE
FORMATION OF THE CONFERENCE AND SUGGEST THAT THE
USE OF SECTION 17(d)(2) OF THE ACT AND RULE 17d-2
THEREUNDER TO ALLOCATE SURVEILLANCE RESPONSIBILITIES
AMONG THE SELF-REGULATORY ORGANIZATIONS IS APPROPRIATE
AND DESIRABLE. IN ADDITION, THE COMMISSION SHOULD
SEND A REPRESENTATIVE TO FUTURE MEETINGS OF THE
CONFERENCE. THE COMMISSION SHOULD ALSO SEEK TO
COORDINATE ITS OWN SURVEILLANCE OPERATIONS WITH
THOSE OF THE SELF-REGULATORY ORGANIZATIONS.

(3 ) Improving Options Exchange Surveillance Techniques
Third, all of the options exchanges do not use the most sophisticated
techniques available to detect improper trading practices. As Appendix 1
reveals, 40/ each of the options exchanges has its own methods of
conducting surveillance activities, these methods varying in scope and
ouality and often in accordance with the surveillance information that is
available to the exchange. With the sharing of surveillance techniques
and information that should accompany the progress of the Self-Regulatory

39/ S. Rep. No. 94-75, 94th Cong. 1st Sess. 2, 32 (1975).
40/ See Appendix 1 at 79 - 141 .

253

Conference, each of the options exchanges should be able to upgrade its

methods of detecting improper trading practices to assure that it is

usinq the most effective techniques available to the greatest extent

oracticable.

Accordingly, the Options Study recommends:

WHEN CONDUCTING OVERSIGHT INSPECTIONS OF
THE OPTIONS EXCHANGES, THE COMMISSION SHOULD
REVIEW THE SURVEILLANCE TECHNIQUES THAT EACH
OPTIONS EXCHANGE IS USING TO ASSURE THAT
THE MOST EFFECTIVE TECHNIQUES AVAILABLE
ARE BEING EMPLOYED.

(4) Uniform Reporting Requirements

The self-requlatory organizations have suggested on numerous
occasions that uniform standards should be developed and applied on
an industrv-wide basis with regard to transaction and position reporting
reouirements. The Cations Study has considered these proposals and agrees
with their thrust.

The position and transaction reporting rules vary from exchange
to exchanoe. While this situation certainly creates the potential
for disoarate treatment of similarly situated people and entities,
the Ootions Studv does not believe that Commission action is warranted
at this time. In view of the approval of the NASD plan to regulate
the ootions activities of broker -dealers who are NASD members but
who are not members of any exchange 41/ and the cooperative spirit

41/ Securities Exchange Act Release No. 15332 (November 15, 1978).

40-940 O - 79 - 19

254

that the self-requlatory orqanizations have demonstrated recently,
the self-requlators may be able to develop requirements, applicable
to all broker -dealers, for positions and transactions that should
be reported for requlatory purposes. Moreover, because each of
the self-requlatorv organizations inouires into essentially the
same tradinq oractices, it may be feasible to standardize inquiry
forms to facilitate the ability of member firms to respond to self-
reaulatory orqanization requests for information. Such standardi-
zation mav result in time and cost savinqs to the industry,
^ccordinaly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD DEVELOP
STANDARDS FOR MINIMUM POSITION AND TRANSACTION
REPORTING RULES AND STANDARDIZED INQUIRY FORMS.
IN THE EVENT TEAT STANDARDS ARE DEVELOPED AND
SUBMITTED TO THE COMMISSION FOR APPROVAL,
THE COMMISSION SHOULD ACT UPON THEM EXPEDITIOUSLY
.AND ADOPT, WHERE FEASIBLE, RULES TO GOVERN
SECO BROKER-DEALERS WHICH ARE PARALLEL TO
SELF-REGULATORY ORGANIZATION RULES.

IV. INVESTIGATION AND ENFORCEMENT

Each of the options exchanqes has proqrams to investiqate tradinq
oractices that its surveillance system detects and which may be inconsistent
with the Act or exchanqe rules. Each exchanqe also has procedures for

255

r'iscinlinina members that violate the Act or exchange rules. During its
inspections, the Ootions Study reviewed more than 700 investigations, through
various stages of completion, that the exchanges had conducted. More
than 300 case files were examined at the CBOE and more than 175 files
were reviewed at both the AMEX and the PSE. The Options Study also
reviewed more than 20 investigations at the PHLX, MSE surveillance logs
for a two vear oeriod, and more than 25 MSE inquiries into questionable
conduct. On the basis of these records and its inspections, the Options
Study has drawn some general conclusions concerning the thoroughness
and effectiveness of the investiqation and enforcement programs
of each exchanne. 42/

1. The CBOE and PSE

The CECE and PSF maintain generally complete records of each inquiry
or investiqation that they conduct. Records usually contain the
surveillance information that prompted the inouiry, notations evidencing
the steps that the investiqator or analyst took to investigate the
auestionable activity, a memorandum or report indicating the recommended

42/ A samole of the information requests and inspection outlines that
the Ootions Study used to perform these inspections is contained in
Aopendix Exhibit 2.

256

disoosition of the case and the reasons for the recommendation, and
documentation to support the recommended disposition. The ultimate
disoosition of the case is also apparent from the files or from
exchanqe records that indicate the status of open cases, matters
pendinq before disciplinary panels, and decisions that disciplinary
panels have made. The staff investigations at these two exchanges appear
to be generally complete and properly analyzed.

At the CBOE, a permanent committee composed of floor members,
nonfloor members, and a representative of the public reviews each
case that the staff has prepared to determine whether there is probable
cause to believe that a violation occurred. If the committee finds
such probable cause, it will issue a Statement of Charges to the
member that may have committed the violation. The committee will
then hold a hearinq and determine whether a violation took place,
and, if so, how the member should be sanctioned. In general, CBOE members
did not appear reluctant to issue charges against and sanction their
oeers when violations were apparent. Moreover, it appeared that the
CBOE has souqht to use the disciplinary process to establish ethical
and leqal quides for the conduct of the membership.

At the PSE, the staff issues a Statement of Charges each time it is
of the view that a violation may have occurred. The staff issues
charqes routinely unless there are "extenuating circumstances."

257

Once charier are issued, a standing committee of floor and nonfloor
members from both Los Anqeles and San Francisco, or a panel of options
floor members, depending on the nature and severity of the alleged
violation, will receive the charges, conduct any hearing that may
be necessarv, and resolve the matter. While the decisionmaking process
at the PSE appeared slower than at the CBOE, its system of peer review
aoneared to function effectively.

2. The PHLX

The Cotions Study's inspection of the PHLX revealed that much of its
surveillance and investigation was done informally. While it appeared
that the numerous options surveillance reports that the PHLX creates and
receives are reviewed daily to determine whether improper trading
oractices may have occurred, investigation usually consists of telephone
calls, reviews of order tickets and reports, and personal discussions
with members. Ffecords of such inquiries and their results are not generally
maintained .

Because there were no records of informal inquiries and few
investigative case files or disciplinary proceedings to review, it
was difficult for the Cotions Study to ascertain the effectiveness and

258

thorouqhness of PHLX investigation and enforcement programs. The few

files and formal oroceedings that were reviewed, however, were relatively

complete and adecuately evaluated.

Accordinqlv, the Options Study recommends:

THE PHLX SHOULD PROVIDE COMPLETE DOCUMENTATION
WITH RESPECT TO ROUTINE SURVEILLANCE FUNCTIONS
AND INVESTIGATIONS THAT THE EXCHANGE PERFORMS.
SUCH DOCUMENTATION IS NECESSARY TO ASSURE THAT
THE PHLX IS CARRYING OUT ITS STATUTORY RESPONSI-
BILITIES PROPERLY.

3. The AMEX

The American Stock Exchange inspection revealed that trading
oractices that may have been inconsistent with the Act or AMEX rules
were often detected. After detection, potential violations were investi-
qated. Like the CBOE and PSE, the AMEX keeps a record of each case that
it investigates , and AMEX case files generally contain a description of
the trading activity that the surveillance staff considered questionable,
surveillance reports that were used to detect the activity, an explanation
of the steps that were taken to investigate the matter , and the recom-
mendations of the analvst for disposition of the case. Handwritten notes
amonq senior staff members frequently evidenced their review of the case
and participation in its disposition.

The Options Study's inspection of the AMEX, however, caused
the Options Study some concern. Most siqnificantly, a troublesome

259

pattern of case closings was observed. 43/ These case closings
involved susoected min manipulation, capping, or prearranged trading
bv AMEX specialists or ROTs. After the questionable trading was
detected, information concerning the specialist or ROT positions
and activity was obtained, and testimony was taken. The specialist
or ROT who enaaaed in the possibly improper conduct then gave an ex-
planation of the tradinq, and the staff, usually after lengthy internal
discussions, and often with some reluctance, closed the case. Because
the AMEX staff is able to issue a Statement of Charges without working
throuah a committee of members, each case was closed without member
oarticio^tion or review. Frequently, staff memoranda indicated that
the case was beinq closed since "the Exchanqe would probably be
unsuccessful in orosecutinq the matter before a disciplinary panel
[of members]" if the specialist or POT "could offer a reasonable
economic explanation" of his activity.

The Options Studv finds these closing procedures troublesome
for four reasons. First, there is almost always some reasonable

43/ The Options Study has not attempted to determine whether violations
of the Act or AMEX rules occurred in the cases that were reviewed.
Rather, the Ootions Study examined the cases to understand the
extent and thoroughness of AMEX investigations after potential
violations are detected, the standards applied in making the
decision of whether to issue a Statement of Charges to a member,
and the circumstances under which investigations are terminated.

260

explanation for tradinq activity, particularly where stock and numerous
ootions series and classes are beinq traded. At the same time, there
is usually another explanation for the activity which, if true,
would involve a violation of the securities laws. As a result, the
existence of a loqical explanation for tradinq should not alone
determine whether a Statement of Charqes should be issued.

Second, since cases are closed if the staff believes that a
nenel of members will not impose disciplinary sanctions under the
circumstances, the staff effectively sets the standards, both leqal
and ethical, for conduct on the AMEX floor with no member involvement.
Even thouqh manv of the closed cases involved tradinq patterns that
were clearly suspicious, the AMEX membership was never formally
consulted with reqard to whether such tradinq should be permitted
on the exchanae. While the independence of the staff must be main-
tained and the membership need not become involved in each investi-
qation or each determination of whether a Statement of Charqes
should be issued, effective self-requlation requires that the
members of the self-requlatory orqanizations play an active role in
defininq standards to quide their tradinq conduct, particularly
where ethical , rather than leqal , standards are at issue .

Third, AMEX analysis of particular fact situations appeared, in
certain instances, to be less careful and thorouqh than that observed
at the CBOE and PSE. Explanations that were qiven for tradinq activity

261

often should have been subjected to more rigorous analysis, and the
details of cases were too freouently overlooked or considered
unimoortant. Perhaps because the AMEX staff is not required to
oreDare cases formally, either for review after closing or for deter-
minim whether a Statement of Charges should be issued, facts and
leqal amuments did not aDDear to be marshalled and presented as
forcefully or as preciselv as the exchange's responsibility under
the Act reouires.

Finallv, case files revealed a number of instances in which the
AMEX reDortino recuirenents and rules concerning the responsibilities
of members to cooDerate with exchange investigations may have been
violated. In some cases, for example, members did not file reports or
keen records that Commission or AMEX rules require; in other cases,
retorts that were filed were inaccurate. In some instances, members
refused to coooerate with the AMEX staff during an inquiry. In none
of these situations was the member disciplined for his activities.

The Study has discussed these concerns with the AMEX. Subsequently,
senior officials at the exchange outlined a number of steps that might
be taken to imrrove AMEX investigation and enforcement programs.
Soecifically, they suggested that a special committee of the Board
of Governors should be established to review regularly all closed

262

case? and that more formal procedures for closing cases should be

devised. With resoect to the special committee, the Options Study

has been informed:

The Exchange Administration will recommend to its
Board of Governors that a soecial committee be
established to make oer iodic reviews of the
Rxchanne's compliance activities. This committee
would consist of the Chairman, the President, the
Executive Vice President for Legal and Regulatory
Affairs, one public governor and two industry
governors (one from the floor and one from
"upstairs") .

This committee would make an in-depth review at
least annually of the investigations and disciplinary
oroceedings conducted by the Compliance Eepartment.
The review would include types of possible improper
activities noted, including any patterns of activity;
standards and orocedures employed in making decisions
at each stage of a matter as to whether it should be
closed or a disciplinary proceeding brought; and
other matters relating to the work of the Compliance
Deoartment. 44/

In addition, the AMEX has undertaken to examine its case closing

orocedures with a view toward formalizing them.

Accordingly, the Ootions Study recommends:

THE AMEX SHOULD FORM A SPECIAL COMMITTEE OF
ITS BOARD OF GOVERNORS THAT WILL REVIEW THE
INVESTIGATION AND ENFORCEMENT ACTIVITIES OF
THE EXCHANGE. THE COMMITTEE SHOULD BE COMPOSED,

44/ Letter to Richard Teberg , Director, Special Study of the Options
Markets, from Norman Poser, Executive Vice President, American
Stock Exchanqe, dated October 3, 1970.

263

AS SUGGESTED, OF FLOOR AND NONFLOOR MEMBERS,
EXCHANCE OFFICIALS AND A REPRESENTATIVE OF THE
PUBLIC. IN ADDITION TO ITS GENERAL REVIEW,
THF COMMITTEE SHOULD SPECIFICALLY EXAMINE, AT
LFAST EVERY SIX "MONTHS, EVERY INVESTIGATIVE FILE
IN WHICH THE INVESTIGATIVE AND ENFORCEMENT
ACTIVITIES OF THE STAFF HAVE BEEN COMPLETED.
THE FILE SHOULD IDENTIFY THE REASONS THAT THE
INVESTIGATION WAS INITIATED, THE STEPS THAT
WERE TAKEN TO INVESTIGATE THE MATTER, THE
CONCLUSIONS THAT WERE REACHED CONCERNING
EACH ASPECT OF THE POTENTIALLY VIOLATIVE
CONDUCT, THE RATIONALE FOR EACH CONCLUSION,
AND FULL DOCUMENTATION TO SUPPORT THE RESULT.

FURTHER, COMMISSION INSPECTIONS OF THE AMEX
SHOULD EMPHASIZE A REVIEW OF CASE FILES THAT
ARE CLOSED AFTER INVESTIGATION TO ASSURE THAT
AMFX ENFORCEMENT RESPONSIBILITIES ARE PROPERLY
CARRIED OUT.

4. The MSF

The MSE keeos a loq of unusual option trading involving MSL options
and anv related stock activity. It also keeos a log of unusual activity
reports that its Order Book Officials file. The Options Study reviewed
these lens for approximately a two vear period and examined every investi-
gative file that the MSE had formally opened.

The review of surveillance logs and reports caused the Options
Studv to question the adequacy of MSE investigation and enforcement
efforts. The loqs contained numerous indications that questionable
tradinn practices may have occurred on the exchange, but MSE records
seldom contained evidence that the matter had been pursued in any

264

wav. As a consequence, it is impossible to determine the regularity,

adeouacv, or extent of exchange investigations of potential improprieties

that its surveillance systems detected. Moreover, the case files

that the Study did review suqgest that MSE investigations may not

be as thorouqh as its statutory responsibility mandates. Cases

were frequently closed before sufficient information had been obtained

to allow a proper determination of whether a violation had occurred,

and there was no indication that clearly improper conduct had been

investigated or sanctioned.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INVESTIGATION
OF THE MSE OPTIONS SURVEILLANCE PROGRAM. THE INSPECTION
SHOULD SEEK TO DETERMINE WHETHER THE MSE HAS THE ABILITY
TO ENFORCE COMPLIANCE WITH THE ACT, THE RULES AND
REGULATIONS THEREUNDER, AND MSE RULES WITH RESPECT TO
OPTIONS TRADING ON THE MSE FLOOR.

265

INHIBITS TO CHAPTER IV

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274

EXHIBIT 7

/©) American Stock Exchange Inc.

REGISTERED OPTION TRADER & SPECIALIST REPORT
OF ORDERS ENTERED IN OPTION RELATED UNDERLYING STOCKS

Datp For the account of

Clearing Agent

Note: To be filed with Trading Analysis Dept. by 11:00 a.m. on the first business day following the date the
order was entered.

(SIGNATURE)

ORDER DESCRIPTION

STOCK

TIME

ENTRY

TYPE OF ORDER

QUANTITY

EXECUTIONS)

POSITION

AT
OPENING

MARKET (Held, Not Held)
LIMIT (Specify price)

Day or
CTC

BUY

SELL

VOLUME

PRICE

275

EXHIBIT 8

MARKET MAKER

DAILY TRANSACTION REPORT

FORM -OTR 1

THE

PACIFIC
s™* EXCHANGE

INCORPORATED

CLEARING FIRM
TRADE DATE

CHECK ONE

B i

0 S

u o

G L
H D

T .

3 S

0 -

H i
T

-
0

p
u

Stock P

Svticci anai R Amount Time Time
or Odto-i 1 of Original Lm.i Oroer Oroer ?'ac; D'
Series C Owe- on Oroer Entered Executed E*ecu:<on

1 III

1 i

PREPARED BY

276

EXHIBIT 9

Mr. Richard Teberg, Director October 6, 1978

Special Study of the Options Markets
Securities and Exchange Commission
500 North Capitol Street
Washington, D.C. 205*5

Dear Mr. Teberg:

We are pleased to submit this letter in response to
the various issues raised by the Special Study of
the Options Markets (the Options Study) with respect
to the need for and creation of an integrated regulatory
system among the self-regulatory organizations (SRO's).
We will first make a preliminary statement concerning
the Option Study's objectives and discussions between
the self-regulatory organizations. We will then offer
substantive comments, preliminary conclusions and
recommendations under four headings: (I) Interchange
of Market Surveillance Information, (II) "Compliance
Plan" for Member Firm Examination and Information
Sharing, (III) Centralization of Compliance Data for
Registration and Investigation Purposes, and (IV) Allo-
cation of Responsibility.

Preliminary Statement

As you are aware, during August, 1978, the staff of the
Options Study held several meetings with representatives
of the following organizations: American Stock Ex-
change, Boston Stock Exchange, Chicago Board Options
Exchange, Midwest Stock Exchange, National Associa-
tion of Securities Dealers, New York Stock Exchange,
Options Clearing Corporation, Pacific Stock Exchange,
and Philadelphia Stock Exchange (hereinafter participant
SRO's or the group). Also participating were represen-
tatives of the Commission's Divisions of Enforcement,
Market Regulation and Consumer Affairs, and Mcnchi k-Weoer
Associates, Inc. These, d iscussions descr iced the Com-
mission's concerns which precipitated the request for
a Proposal For A Market Surveillance System as awarded
to Monchik-Weber Associates, Inc. as well as the pre-
liminary findings of the Options Study which indicate
the need for greater coordination of existing options
and securities regulatory systems so as to achieve
an integrated industry-wide regulatory system.

277
Mr. Richard Teberg Page Two

The meetings of the participants have focused upon the
need for the creation of an integrated regulatory system
among the SRO's which would enhance total industry regu-
latory capability by coordinating and interfacing exist-
ing regulatory data and programs through the sharina of
available information, improvement of regulatory tech-
niques, the allocation of regulatory responsibility and
the centralization of registration data and customer com-
plaints to facilitate access.

In particular, the Options Study has noted several areas
of concern which are indicative of its findings and which
should be addressed in order, in its opinion, to im-
prove overall regulatory capability of the SRO's. The
main objectives would be to eliminate overlapping ef-
forts which may presently exist, to fill existing voids
in regulatory programs and to promote the interchange
of and access to information. This is especially true
with respect to dual trading in options and stocks ar.d
intermarket options activities. These concerns center
upon whether there is a need for the SRO's to:

(1) share and improve existing data bases and in-
crease inter and intra-market cooperation;

(2) to enhance audit trails to promote intermarket
reconstruction and surveillance;

(3) enhance regulation of off-floor proprietary
and customer accounts;

(4) establish audit trails for position adjust-
ments, "as of transactions ar.d Clearing
Member Trade Assignment arrangements;

(5) establish minimum uniform standards which
trigger surveillance follow-up activity;

(6) establish uniform forms and letters request-
ing additional information from broker-
dealers with the elimination of duplicate
inquiries in the case of multiply traded
options and the underlying security;

(7) receive and process relevant information from
each SRO regarding registered personnel and
to utilize such in preparation for regulatory
examinations and investigations;

278
Mr. Richard Teberg Page Three

(8) conduct more examinations of member firms which
may incorporate regulatory methods and practices
which have not been routinely utilized by all
SRO's in the past;

(9) establish the method, form, and principles
upon which information available to one or
more SRO's will be accessed by other SRO's;
and

(10) establish uniform minimum compliance and dis-
ciplinary programs.

The Options Study also recognized the importance of
enhancing regulation of broker-dealers who, though
not a member of an options exchange engage in ex-
change listed options activity by going through a
clearing member (so called "access firm"). How-
ever, this prodem appears to be nearing resolution
by the Commission's recent conditional approval of
the NASD's "access" rule proposals. This situation
would be further improved if the SEC would now adopt
and approve comparable rules to regulate SECO and
other broker-dealers not covered by the rules governing
access firms or any other specialized options rules.

Although it is recognized by the participant SRC's

that complete integration of regulatory information

and systems may present technical and feasibility

questions, it is acknowledged that the establishment

of a more fully integrated regulatory system is

both necessary and desiraole as a means of establish ino

more efficient and effective regulation which may

be cost-effective to the industry and achieve minimum

standards of regulation on an industry-wide basis

thus assuring the protection of public investors.

Significant progress has been made by the particioants
toward the creation of an integrated regulatory system.
Numerous meetings and discussions have been held by the
group and sub-groups formed for the purpose of focusing
on specific issues including (a) interchange of ^arke:
surveillance information, (b) interchange of compliance
Information relating to firm examinations and sales
practices, (c) development of central files for regis-
tered personnel and customer complaints, (d) allocation
of regulatory responsibilities, and (e) leqal matters
to be addressed in order to achieve an integrated
regulatory system.

279

Mr. Richard Teberg Page Four

As a result of these discussions, the particioant
SRO's listed above met jointly for the purpose of
defining the ovrrall parameters of a comprehensive
regulatory system cased upon their complete and
thorough understanding of the capabilities presently
in place and, following such analysis, to make recom-
mendations for the implementation of the system.

The group, based upon the reports and recommendations
of its sub-groups, and its own deliberations to date,
has achieved agreement in several specific areas
and wishes to submit this preliminary report to acpris-
the Options Study of the material developments which
have occurred and to focus attention on those areas
which, although approved in principle by the various
SRO's, remain to be fully resolved before considera-
tion may be given to their later implementation. It
is clear, however, that continuing efforts will be
required in order to reach mutually satisfactory solu-
tions and that further meetings of the SRO's Wie-
the Commission's staff will also be required to
facilitate the implementation of desired programs.

I. Interchange of Market Surveillance Information

A sub-group was established on interchange of Market
Surveillance information. This body was directed
to identify all market surveillance reports and
information presently available to each participant
SRO in order to determine whicn information could
be integrated into other self-regulatory organizations'
programs to enhance existing regulatory efforts with
respect to intermarkei surveillance. This sub-croup
thereafter collected from and furnished to each par-
ticipant SRO, including the Options Clearing Corpor-
ation, copies of all option and equity computer
print-outs and certain manually prepared reports
(along with explanatory materials identifying the
type of data, format, frequency and purpose) which
are utilized in conducting market surveillance for
listed securities. In addition to disseminating
examples of data base information derived from
transaction and clearing streams, each organiza-
tion provided copies of reports which identify
activity which exceeds pre-determined parameters
during a trading session.

After the analysis of this voluminous information,
a better understanding of the nature of information
available was achieved. There was also a consensus
that the sharing of data by the various SRO's is
both needed and desired. However, while certain
agreements have been reached, it is yet to be deter-
mined whether all such information will be furnished
routinely or on some other basis. .

280

Mr. Richard Teberg Page Five

It is generally agreed that any information inter-
changed may be more desirable in a computer readable
format ratner than on microfiche or hard copy print-
outs for manageability and flexibility purposes.

Ful .her , it is noted that certain data which would
be useful to each organization is presently avail-
able on an on-line basis through sucn systems as the
OTIS system for collecting and displaying option in-
formation and for stock activity from the last sale
and quote information transmitted via high speed
lines. This information may be captured with ao-
propriate programming which is being explored.

During a general discussion of the adequacy of option
and stock data bases and audit trails, it became ap-
parent that a significant difficulty in an effective
and efficient integrated system is the reconstruction
of transaction data on the underlying security in a
form which identified the broker/dealers involved in
each transaction and whether they are actina as agent
or principal. Various participants expressed concern that
such a system mignt be very expensive to construct and
maintain and that these costs must be weighed.

After identifying the information available, the par-
ticipant SRO ' s expressed interest in the exchange of
market surveillance information as follows:

a) Reconciliation Clearing Sheets from markets where
securities underlying options are traded.

b) Daily Transaction Journal from all markets where
securities underlying options are traded.

c) Monthly Short Interest Reports by firm from all
markets where securities underlying options are
traded .

d) Block trade reports from all markets where securi-
ties and options are traded.

e) Notification of the initiation of investigations and
reviews, as appropriate.

f) Status reports on investigations and reviews, as ap-
propr iate.

g) Notification of trading halts.

281

Mr. Richard Teberg Page Six

h) Notification of corporate contacts resulting from
unusual trading activity.

i) Exercise/Assignment Listing Reports from OCC.

j) Open Interest Distribution Reports from OCC.

k) Market Data Retrieval Reports and Matched Trade
Listing Reports.

The equity exchanges indicated that they would be
responsive to inquiries by the options exchanges with
respect to matters which could affect trading in unde:
lying securities and options trading thereon and wouli
make every effort to inform other appropriate market
centers of trading halts.

With respect to the interchange of information per-
taining to multiply listed options, we believe that
useful data is currently being disseminated to the
options exchanges via the daily Options Clearing
Corporation compliance tape and that modifications
due to be implemented in the beainning of 1979 will
enhance monitoring capaoilities oy providing member
transactions in multiply traded classes executed on
other exchanges. These modifications, as currently
envisioned will consist of each participant SRO re-
ceiving the following:

a) All positions, exercises/assignments and ad-
justments of their memoers regardless of
where the options class is listed;

b) All cleared options transactions of their
market maker s/spec ial ists/reg istered traders;
and

c) All exercises, assignments, positions and adjust-
ments of non-members trading in classes which
are solely listed on their exchange.

There is general agreement among the participant SRC's
that they are willing to share information for surveil-
lance purposes subject to certain specific limitations,
i.e. non-member specialist and marketmaker positions
which would be provided on a case-by-case basis rather
than as a matter of routine. It is important to note
that the participant SRO's agree that all information
would be available to other SRO's for specific investi-
gations.

282

Mr. Richard Teberg Page Sever*

It was suggested that rather than receive information
from each option exchange the Options Clearing Corpor-
ation upon appropriate authorization could furnish a
modified daily compliance tape to non-OCC participant
SRO's which would contain the in'ormation requested
except for data pertaining to non-member specialists,
traders, and mar ketmakers.

The group recognizes that there could be problems in-
herent in providing an SRO information pertaining to
a non-member of that participant. It remains to be re-
solved whether such information is to be furnished on
a routine basis or only upon request.

With respect to the legal question of providing a par-
ticipant with information pertaining to a non-member,
the legal sub-group raised questions of legal liability.
It believes, however, the potential liability of SRO's
would be decreased if the action taken (a) is pursuant
to legitimate regulatory objectives under the Securities
Exchange Act of 1934 and does not involve excessive cr
gratuitous compromise of privacy or due process rights;
(b) has been duly authorized by the SRO's and approved
by the SEC; and (c) each SRO has implemented appropriate
rule changes to the extent necessary and/or has required
proper disclosure.

I I . Compliance Plan for Member Firm Examinations and
Information Snar mg

We established a sub-group to review current industry
compliance practices toward the goal of developing a
more standardized compliance program. This program would
utilize in part the concept of a central report mg of
relevant information concerning memoer firms. The aims
of such a program would be, among others, to promote
a sharing of relevant information aoout broker /dealer
compliance activities and to ass"ist in the execution
of complete, comprehensive and thoroucn examinations
of such firms. In addition, the group agrees with the
Options Study that it should be possiole to establish
some industry-wide ODjectives for the conduct of an
examination so as to insure the protection of investors,
avoid regulatory duplication, and eliminate regulatory
voids.

It is agreed that a broad "Compliance Plan" would include

I. Continual Monitoring Proqrams

II. Special Attention Programs

III. Examination Programs

IV. Disciplinary Programs

V. Educational Programs

283

Mr. Richard Teberg Page Eight

While we acknowledge that most, if not all, of the'
basic components of the programs noted above are
place and presently being utilized by one or more
of the SRO's, it is also agreed that certain of these
programs may have to be further refined so as to
increase their comprehensiveness and to facilitate
their use, as deemed appropriate, by each SRC.

We therefore agreed that the sub-group would reach an
understanding as to the components of each program
within the compliance plan and the objectives to
be achieved by each such component. In addition,
the sub-group would compile a list of the particular
data bases which could be utilized to accomplish
the objectives of each program component. The sub-
group is making progress in the above area and will
submit its future recommendations on these matters
to us for review and action.

In addition to the above, we have agreed that the com-
pliance plan sub-group should include within the scope
of its discussions matters such as:

the targeting of, and visits to, branch offices
for examinations;

• the enhancement of examination "audit
trails ;"

the uses of "intelligence" information re-
ceived frcm other SRO's; and,

a comprehensive pre-examination procedure.

III. Centralization of Compliance Data for Registra-
tion and Investigation Purposes

We established a sub-group to review the feasibility
and usefulness of creating a central repository for
compliance information. As a result of the sub-group's
recommendation we have determined that a repository
could be utilized to provide each self-regulatory
organization with more information than is presently
utilized for purposes of registration of personnel,
customer complaints, investigations and examinations.
We also believe that measures should be taken in
this area to decrease or eliminate duplication of
efforts among self-regulatory organizations and in-
crease the overall efficiency of such processes
within the industry. The group further aqrees that
the adoption of these measures should not, to the
extent feasible, result in increased costs to the
industry.

284

Mr. Richard Teberg Page Nine

The group discussed the concerns of the Options Study
regarding the concept of a registered representative
who transferred from firm to firm and through vari-
ous regulatory jurisdictions. It was agreed that a
central repository of registered personnel and cus-
tomer complaints may assist in following the movements
of such an individual and provide SRO's with more com-
prehensive data by which to judge his actions.

The NYSE offered to become the central repository for
general compliance information for those firms for
which it is the designated examining authority. The
NASD offered to include data elements relating to
customer complaint information on its automated system
for processing registered representative applications.
Such system presently contains certain data elements
of interest to the suo-group including termination
for cause information and final disciplinary actions
taken against registered personnel. Each SRC agreed
to furnish the NASD with output requirements they
would need from such central repository system with
the understanding that the NASD will outline for con-
sideration a system designed to meet tneir needs.

To date there has been no general agreement as to how
information could be used except to provide "intel-
ligence" for SRO's preparing for examinations ar.d
investigations. There was concern as to potential
legal obstacles which could prevent information
sharing, however, we have 'concluded that potential
legal liabilities would be reduced if the procedure
outlined on page 7 is pursued.

The group has agreed that, aside from the feasibility
of such a plan, a central file on registered personnel
which would include at least all information regard-
ing registration and termination, customer complaints,
and formal actions ta<en oy SRO's and other regulatory
bodies would be a worthwhile accomplishment. It is
generally agreed that such information would assist
each participant in determining whetner registration
was appropriate, whether closer than normal surveillanc
was warranted and would provide information useful in
the preparation and conduct of investigations and ex-
aminations .

Additional questions were raised concerning access
to such information and whether or not such a re-
pository would include matters which have not yet
reached a conclusive state at a regulatory body.
Representatives on the sub-group have agreed to review
the position of their organization with regard to the
sharing of this information keeping in mind the goal

285

Mr. Richard Teberg Pace Te

of accomplishing the total sharing of information
whenever possible. Additionally, the sub-group has
determined to address and resolve questions regarding
the methods of implementing such a proposal, access,
refinements in the use of information and the re-
sponsibilities of users.

IV. Allocation of Responsibility

We established an allocation of responsibility sub-
group to explore the means of identifying ar.d elimin-
ating duplicative regulatory efforts as well as the
measures necessary to improve regulatory programs.
The sub group was also requested to provide the -earns of
resolving such overlaps and shortfalls through the
allocation of responsibility for investigation and
enforcement and to assure, as much as possible, the
uniform interpretation and application of co~paracle
self-regulatory and Commission rules. The group focused
on problems involving jurisdictional issues where
membership in more than one self-regulatory organiz-
ation existed ar.d on inter-market trading activities
which transcended individual SRC jurisdictional
boundaries, soon as insider trading activities,
fraudulent and manipulative trading practices, tape
racing, front-running, expiration studies and other
specific inter-mar<et transactions.

Por purposes of its discussions, the participants
determined that non-member oro <er-dealers ar.d non-
member broker-dealer customers would oe treated as
the same type of entity for surveillance purposes.
It was also determined that where a ncn-memoer
(whether a broker-dealer or customer) effects a
transaction using the facilities of a member bro-
ker-dealer, the matter should be referred to one
SRO that has jurisdiction over that non-member
or to the SIC if a non broker-dealer customer is
involv ed .

Of course, questions of jurisdiction over a broker-
dealer which is a member of more than one self-regulatorv
organization and/or when a security is multiply traded
encompass much broader and complex issues arc conse-
quently consumed a significant portion of the aroup's
efforts. Based upon its discussions, the croup
agreed to consider the followinq principles of allo-
cat ion:

40-940 O - 79 - 21

286

Mr. Richard Teberg Page Eleven

(1) The surveillance and regulation of specialists,
market-makers and registered floor traders will
be retained by the self-regulatory organiza-
tions of which they are a member and on which
they fulfill such functions.

(2) The gathering of customer and firm information
needed in pursuing insider trading and manipulation
cases shall be allocated to the primary market in
that family of markets whenever there is a dually
traded security.

(3) Whenever an SRO conducting an investigation lacks
jurisdiction over a broker-dealer non-member,

the information necessary to conduct the inves-
tigation shall be obtained from any other self-
regulatory organization of-vnich such non-member
is a member .

(4) Expiration Studies - It was agreed that the SRO's
would inform each other when they are preparing
to conduct expiration studies of options vs.
stocks in order to prevent a duplication of ef-
fort. If two or more self-regulatory organizations
have decided to perform a similar study, they would
determine among themselves which would conduct the
study; however, where market-makers, specialists
and registered floor traders are involved, the
self-regulatory organizations of which they are

a member shall retain responsibility for inves-
tigating such matters.

(5) Disciplinary Procedures - Self-regulatory organi-
izations shall share information while retaining
jurisdiction of their own members; however,
where joint members are involved the market
where the violative activity occurred would be
responsible for disciplining the memoer unless
otherwise agreed upon.

(6) Employees of SRO's will be made available for
testimony as needed by other SRO's in any case
where their testimony is required or where
such employees performed a portion of an inves-
tigation or examination. (The self-regulatory
organizations will continue to review the oos-
sibility of requirina their members to testify

at disciplinary hearings of other self-regulatory
organizations which lack jurisdictional authority
over such members.)

287

Mr. Richard Teberg Page Twelve

In agreeing to these principles of allocation, we note
that certain initiatives in these areas have previously
been undertaken in the form of 17d-2 agreements which
have been entered into by t.ne various participants and
filed with the SEC. We urge the Commission to promptly
review and act upon those agreements which it has not
yet considered. ' In doing so, • -e recognize that they
are not all inclusive in respect to the matters which
are the subject of our discussions and that amendment
of the 17d-2 agreements may be appropriate as these
matters are implemented.

To accomplish our goals, it is anticipated that there
will be further discussion by the participants to
allocate additional responsibilities with respect to
matters arising from inter-market regulatory prcc-
lems and to further eliminate regulatory duplication.

The above presentation is a summary of principles
agreed upon oy staff representatives of the participan
SRO's and those questions remaining to be resolved
prior to achieving our objective of establishing
an efficient and effective integrated inter-mar icet
regulatory system. We are continuing to -meet in an
effort to achieve such a system. It must be borne
in mind, however, that certain aspects of these
programs would require formal action by the acvernir.g
bodies of the respective SRO's. Continued cooperation
on behalf of the SEC will, of course, be necessary
in order to achieve and implement these goals.

We welcome the Commission's participation at future
meetings.

Very truly yours

Amer ican Stock Exchange

Boston Exchange Exchange

288
Mr. Richard Teberg Page Thirteen

Chicago Board Options Exchange

Midwest Stock Exchange

National Association of Securities Dealers

New York Stock Exchange

Options Clearing Corporation

Pacific Coast Stock Exchange

Philadelphia Stock Exchange

CHAbTEK V
OPTIONS SELLING PKACTICLb

lNTrtJUUCTlON

Tne Options btudy exajuinea tne manner in wnicn brokerage firms
ana tneir registered representatives sell listed options to the pub-
lic in order to determine it signincant patterns of selling practice
auuses existed, borne or tne selling practices surveyed were sound,
wniie others appeared unetnicai and still otners were clearly unlawful,
inereiore, tne internal controls and procedures of brokerage firms were
analyzed lor tne specilic weaknesses wnicn had permitted these abuses
to occur. Mitnougn no attempt was made to quantitatively measure unsound
selling practices throughout the industry or tnrougnout a firm, it became
eviuent tnat, wnerever brokerage firms lacked adequate internal controls,
serious selling abuses were lixely to occur, most options selling abuses
are rooteu in tne failure of many brokerage firms to prohibit registered
representatives trom selliny listed options to the public before the
rirms tnejiiseives nave estaolisned necessary supervisory systems to control
tneir sales rorce. In many firms adequate internal controls are still lacking.
Tnis cnapter uiscusses tne selling practice abuses and internal control
oenciencies lounu by tne Options btudy.

Tne Uptions btudy naa access to ail the Coniuiss ion's investigative
rues relating to options selling practices and reviewed more than one
nunarea ana tirty options examinations of broker-dealer rirms conducted

(289)

290

bv the Commission's staff during the past 15 months. The Options
Study also reviewed the options complaint files of the Commission
and those of brokeraqe firms of all sizes and interviewed compliance
and sales personnel from brokeraqe firms. Finally, to gain a better
oerspective of their options business policies, and internal controls,
the Ootions Study sent a detailed Questionnaire to a sample of brokerage
firms sellinq listed options to the oublic. The sample consisted of
all brokeraqe firms carrying and clearing their own public customer
accounts which reported to the Commission listed options commission
revenues for 1977 of $500,000 or more (46 firms) and a random sample
drawn from 89 smaller brokerage firms whose listed options commission
revenues for the same period were between $100,000 and $500,000 (12
firms). The 58 firms which comprised the industry group sample
accounted for more than 70 percent of the total options commission
revenues earned in 1977 by brokeraqe firms which dealt with public
customers.

Brokerage firms are required by both the Exchange Act and the
rules of self-renulatory organizations to maintain adequate systems
of suoervision and control over the activities of all their employees.
A brokeraqe firm's suoervision of its employees must be adequate to
orotect its customers from illegal and unethical practices because,
as the Commission has explained:

291

Customers dealing with a securities firm
exnect, and are entitled to receive, oro-
oer treatment and to be protected against
fraud and other misconduct, and may properly
rely on the firm to provide this protection. 1/

A hiqh standard of supervision over registered reoresentatives

is reouired because of the Dotential for abuse of a customer's

trust. Cne court recently noted:

The registered representative and the broker-
dealer earn their money, directly and indirectly,
by sales activitv. Customers often rely on their
broker-representatives for investment advice.
"The ooDortunity and temptation to take advantage
of the client is ever oresent.' 2/

The complexity and leverage features of listed options trading
pose siqnificant risks for public investors and reouire unique super-
visory systems within broker-dealer firms. Adequate supervision of
listed options trading reouires brokerage firms to actively and con-
tinuously ensure that knowledqeable supervisory personnel oversee the
activities of registered reoresentatives, that registered representatives
are adequately trained and that they transact business only with those
customers who can aporeciate and bear the risks which options trading
entails. As oart of its suDervisory responsibilities, each brokerage
firm must oerform timely reviews of its account openings and of the

_V Peynolds & Co., 39 SEC 902, 917 (1960).

2/ Kravitz v Pressman, Frohlich & Frost, Inc., 447 F. Suoo. 203,
213 (D. Mass. 1978)

292

selling documents shown or sent to customers. In addition, each firm
must systematically oversee the trading activity in customer accounts
and toliow sound recordkeeping and back-olfice procedures.

In uiany cases examined by the Options Study, customers have
suirered unnecessary losses that might have been prevented by adequate
supervisory controls, for example, because brokerage commissions alone
provide a strong incentive tor registered representatives to recommend
listed options, tne Options Study tound tnat customers had been switched
irom conservative long-term investment positions into active short-term
trading in listed options witn little or no regard to the suitability
or tnis new type of trading tor the customer. Other customers were
initially attracted to options trading by misleading advertising and
otner promotional materials produced by the firm or its registered
representatives. Altnough some of these customers did not understand
options, or nave tne financial ability to bear the risks of options
trading, tney were permitted to open options accounts and trade options.
Too trequently, registered representatives, lacking proper training
and supervision, involved customers in elaborate options transactions
or programs so complex that neitner they nor their customers fully
understood tnem. as a result, these transactions were occasionally
constructed in such a way that, unknown to tne customer, the best
outcome ne could possibly achieve would be to break even. In other
transactions, tne customer's maximum potential profit was much less
tnan tne commissions ne was charged.

293

Customers generally are not provided adequate, usable information
to enable them to appreciate fully the risks or results of trading listed
options. Monthly account statements, which are supposed to inform the
customer of the status of his account, generally do not give the customer
sufficiently detailed information to monitor his trading activity. Options
customers, on the other hand, often do receive from brokerage firms
detailed selling documents, such as worksheets and performance reports.
These documents may be misleading because they sometimes provide little
or no exDlanation of the risks of the options transactions being recommended,
or because they contain unrealistic projections of high rates of return.

Most brokerage firms rely on a system of branch office managers,
comolemented bv a home office compliance unit, to oversee the trading
in customer accounts. Many local supervisors, however, are not properly
oreDared to understand options or to control listed options trading
in customer accounts. Similarly, home office compliance systems often
do not provide adeouate review of customer options trading, especially
trading in discretionary accounts opened as part of some options investment
programs. These problems of supervision are further compounded by
inadequacies in certain back-office and recordkeeping practices which
decrease the efficiency of both the firms and regulators in determining
compliance with rules.

294

un tne oasis of its review, tne Options Study is recommending
changes in tne rules ot self -regulatory organizations for the
purpose ot improving and strengthening internal control systems
in oroKerage tirms. Tne Options Study recommends that these
minimum requirements be imposed on all brokerage firms selling
listed options to tne public regardless of the self-regulatory
alt illation ot the lirm.

Tne examples used in the chapter to illustrate abuses and
regulatory problems are drawn from the Commission's files. All
customer accounts described were selected from among actual cus-
tonter accounts analyzed by tne Commission's staff although sane
numbers nave oeen rounded and, in one case, part of an account
was deleted to simplify analysis without compromising conclusions.
Names ana dates nave been changed wherever appropriate. Excerpts
iroiii registered representative - customer conversations or from
sworn testmony are taken from tapes and transcripts reviewed
oy tne Options Study.

Certain selling practice issues which the Options Study has

not addressed, but which deserve future scrutiny by tne Commission and

its statf, are:

. Exercise practices, at botn OCC and broker-dealer
iirms including tne fairness of certain practices
sucn as automatic exercise and exercise of abandoned
customer options and tne risks tnese and other
exercise practices entail for public investors;

295

The role of the investment adviser as an options
consultant and the relationship of options advisors
and their services to brokerage firms;

The relationship between options selling practices
and the growth in the number and size of margin
accounts;

The relationship among firm proprietary trading,
firm research recommendations on underlying stock,
customer options trades and the recommendations
made to customers;

The effect of listed options trading on the customer
account transfer practices. of brokerage firms.

The need for an options regulatory program for
SECO broker-dealers.

296

A. REGISTERED REPRESENTATIVE QUALIFICATION, PREPARATION AND MOTIVATION
1. Introduction

The soundness of oDtions selling practices rests ultimately on
the training and attitude of the persons who sell options to the public.
While many of the sellinq practice problems found by the Options Study
miqht have been avoided if brokerage firms had better supervisory or
surveillance programs, the first means of avoiding such problems is
to establish controls and to develop incentives which encourage integrity
and promote hiah standards of performance on the part of registered
representatives who deal directly with public investors.

A number of controls and incentives are essential if high stand-
ards are to be established and maintained:

(1) First, the industry-wide requirements for allowing
individuals to become "qualified" as options salespersons should
be stringent enough, and the on-the-job and classroom training
provided to registered representatives within each firm should

be riqorous enough, to assure that only persons reasonably proficient
in options are permitted to sell options to the public.

(2) Second, a system of incentives must be developed within
each firm to encourage registered representatives to give adequate
consideration to their customers' best interests when recommending
or effecting options transactions for customer accounts.

297

(3) Third, the hiring and termination practices in the industry
must be directed toward assurinq that oersons seeking employment
as registered representatives are properly screened, and that registered
representatives who have demonstrated an inability or unwillingness
to deal fairly and honestly with their customers are removed from
the business.

In all three areas, the Ootions Study has found that controls
are inadeouate to assure that only knowledgeable and properly
motivated registered representatives sell listed options to the public.

2. The Qualifications of Persons Who Sell Options

Several of the options-related customer problems reviewed by the
Options Studv were caused by registered representatives who did not
understand listed options. These problems might have been avoided
if the registered representative involved had been required to
undergo a meaningful Qualifying and training process before he was
oermitted to sell options to customers. The present requirements
are inadeouate in this regard, and, as a result, many registered
representatives now servicing the accounts of options customers
lack the necessarv knowledge and skill to perform their functions
Drofessionally.

298

a. The options qualifying examination
The options exchanges all require that employees of member firms
be registered with the exchange before they are permitted to sell that
exchanqe's listed options to customers. As a prerequisite to registra-
tion, the salesperson must pass an options qualifying examination.

Two examinations are presently in use. The NASD "Series 7"
Qualifying examination is given to all applicants who are new to the
securities industry and who are seeking to become registered to sell
securities for the first time (i.e. , to become "registered represen-
tatives"). The "Puts and Calls" examination is given to persons who
are already registered representatives, but who passed the Series 7
examination (or became registered on the basis of earlier standards)
before listed options were included in the registration requirements. 3/

The Series 7 examination consists of 250 multiple choice
questions and covers virtually all types of securities products
available to investors. Questions relating to listed call options
have been included in the examination since May 1977. At present,
approximately twenty questions — eight percent of the examination
— directlv concern options, and, on occasion, as many as ten more

3/ For a short period of time the Series 7 examination included
questions on calls but not puts, and persons who took the test
during that period subsequently had to pass a separate "Puts"
examination if they wished to offer puts to customers.

299

•questions may ue devoted to tne margin treatment of options trans-
actions. An applicant must achieve a seventy percent correct score
to pass tne examination (175 correct answers); none of the subjects
is scored separately. The examination is "closed book" and is
administered once a month at various NASD testing centers around
tne country.

as presently structured, the Series 7 examination has little
relationship to tne actual qualifications of a person to sell listed
options. Since only twenty questions directly concern options and
since an applicant may miss a full seventy-five questions without
tailing the examination, an applicant may miss every options question
and still Decome "qualified" to sell options.

un tne otner nand, the "Puts and Calls" examination, which consists
of rorty to titty multiple choice questions, is devoted entirely to
options. To pass this test, a person would appear to need some
understanding of tne product. As with the Series 7 examination,
nowever, the industry nas permitted those who take the "Puts and Calls"
test to pass it witnout necessarily possessing any knowledge of options,
t'lrst, tne examination is given "in house" which means that brokerage
tirms may devise their own procedures for administering the test. The
opportunity for abuse is apparent, and it is not surprising that rumors
aoound as to widespread misconduct in the administering of the test.

300

second, no otficial passing grade has ever been established for the
examination (altnougn a "rule-ot-thumb" seventy-five percent passing
score nas been suggested by tne CBOE). The established brokerage firm
procedure following the examination is tor the options supervisor
wno administered tne test to "review" with each candidate his incorrect
answers and then to retest him until ne "passes." For this reason, the
"Puts and Calls" test, like tne Series 7 examination, does not serve to
assure tnat options "qualified" registered representatives are know-
ledgeable about options.

In view of the present unsatisfactory status of the qualifying
examinations given to persons seeking certification to sell options
to tne public, the Options Study recommends:

THE SELF-REGULATOKY ORGANIZATIONS SHOULD AMEND
THEIR RULES TO REQUIRE THAT THE REGISTERED
REPRESENTATIVE "OPTIONS QUALIFYING" EXAMINATIONS
BE REVISED TO REQUIRE A THOROUGH KNOWLEDGE OF
UPl'IONS AND OF APPLIABLE OP1IONS RULES DESIGNED
TO PROl'ECT CUSTOMERS. THESE EXAMINATIONS SHOULD
b£ REaU'iINISTERED TO ALL OP1IONS SALESPERSONS,
AND ALL EXAMINATIONS SHOULD BE GIVEN UNDER CONTROLLED
SURROUNDINGS Bf INDEPENDENT EXAMINERS.

o. The training requirement

Tne rules of tne AMEX and CBOE provide that, in order to be

registered, a prospective options salesperson must not only pass

an options examination, but must also "successfully complete a

training course" (CBOE) or "nave a minimum period of four months

301

traininq and experience" (AMEX). _4/ The training component of
the registration reouirement is not strictly enforced, however, •
so that firms are free to decide for themselves how much, and
in what manner, options traininq should be given to prospective
salespersons. As a result, the amount of time and effort devoted
to classroom and on-the-iob training varies widely from firm to
f ir™.

Reqistered representatives who wish to offer options to customers
should be given practical, supervised, on-the-job training which the
oresent svstem does not assure.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO REQUIRE THAT THE TRAINING OF REGISTERED
REPRESENTATIVES WHO RECOMMEND OPTIONS TRANSACTIONS
TO CUSTOMERS BE FORMALIZED TO INCLUDE A MINIMUM
NUMBER OF HOURS OF APPROVED CLASSROOM AND ON-THE-
JOB INSTRUCTION.

3. Motivation

Adeauately trained and tested registered representatives must

also be oroperlv motivated if they are to serve customers fairly. 5/

_4/ Rule 9.3, CBOE Guide (CCH) f 2203;
Rule 341, 2 ASE Guide (CCH) 1| 9391.

5 / The dutv of a registered representative to inquire about a

customer's investment objectives, financial situation and needs
and, based on that information, to determine whether or not
options transactions are suitable for the customer , is dis-
cussed in subchapter C, "Suitability", infra.

40-940 O - 79 - 22

302

But, reqistered representatives are subject to a serious conflict
of interest that arises from the dual role they must play when servic-
inq customer accounts. On one hand, the registered representative is
an advisor to his customers and an agent who ought to act with his
customers' best interests in mind. At the same time, in most firms the
reaistered representative is a salesperson whose only, or principal,
comoensation comes from commissions which are related to the size and
freouencv of transactions in his customers' accounts. This compensation
system creates a temptation for the reqistered representative to effect
trades in his customers' accounts - trades which may or may not be in
the interests of his customers - in order to derive income.

Coupled with the short-term nature of options, the industry's
commission rate structure makes options a particularly attractive sales
item to a reqistered representative whose livelihood depends upon
commissions. The commission structure of the securities industry has
traditionally called for hiqher charqes for transactions in low-priced
securities. This structure has been retained in the commission
rates most firms charqe their options customers. For example, a
customer qenerally will pay a larqer commission on an options trade
consistinq of 10 calls at $5 ($500 per contract) than on a stock
trade consistinq of 100 shares at $50, even thouqh the value of the
securities in both transactions is $5,000.

303

To aive a soecific example, consider an investor who buys 5
call contracts, or iced at $200 a contract, for a total purchase
or ice of $1,000, olus commission. Most firms do not calculate
this commission as thouqh 5 units were purchased at $200 each.
Instead, each call ootion contract is equated to 100 shares
of stock, and the option on each share is assigned a unit value
of $2. The commission is based on a purchase of 5 contracts of
100 units each, or 500 units at $2 for each unit. Using rates
tyoical in the industry, the investor is charged $57.20 for 500
units at $2 instead of $25.00 for 5 units at $200.

The Ootions Study requested from each firm in the industry group
samole a current commission rate schedule. Table I below summarizes
certain of the information provided. This table displays commissions
as a oercentaqe of the cost of buying 100 shares, 500 shares and 1000
shares of stock at $50 oer share, and 1, 5 and 10 options contracts
eouivalent to 100, 500 and 1000 units at prices of $.87, $5 and $10
oer unit.

304

The
Trade

Dollar
Value
of Trade

TABLE I

Industry
Sample Range

Average
Commissions As
industry Percentage of

Sample Average Dollar Invested

low

high

1 call (a $ .87

$ 87.50

$ 6.25

- 30.00

$ 13.77

15.74%

5 calls (a .87

437.50

20.00

- 53.75

40.44

9.24%

10 calls O .87

875.00

35.00

- 101.60

78.34

8.95%

1 call <a $5

500.00

18.04

- 29.40

23.30

4.66%

5 calls @ $5

2500.00

74.50

- 106.70

86.83

3.47%

10 calls <a $5

5000.00

127.00

- 181.05

149.16

2.98%

1 call 0 $10

1000.00

25.00

- 37.50

29.08

2.91%

5 calls (? $10

5000.00

97.00

- 132.89

114.08

2.28%

10 calls @ $10

10000.00

172.00

- 247.68

211.26

2.11%

100 shares <a $50

5000.00

71.50

- 96.12

82.18

1.64%

500 shares @ $50

25000.00

325.00

- 390.48

343.64

1.37%

1000 shares (a $50

50000.00

499.28

- 599.14

524.97

1.05%

As Table I portrays, the commission rate applied to low-priced
securities is substantially higher than that applied to higher
oriced securities. Three trades involving an investment of $5,000
are included: 100 shares at $50, 5 call contracts at $10, and 10
call contracts at $5. The commission charges (industry average)
for these trades are as follows:

100 shares @ $50

$82.18

5 calls @ $10

$114.08

10 calls @ $5

$149.16

The higher commission structure on listed options, however, is only one
of the incentives to a registered representative to recommend listed
oDtions to his customers.

305

This incentive is qreatly magnified by the opportunity for repeated
trades of ootions which is a result of their limited life span. For
examole, assume a customer desirinq to buy 500 shares of Upjohn
at $50 oer share could be convinced by his registered representative
also to start a covered options writing program by writing five
Uoiohn calls three months from expiration, and to repeat the process
at each exoiration date. The registered representative could real-
istically anticipate eight to twelve additional commission charges
durina the next year, iust from the options. Thus, based on the
industry arouo samole commission average, the registered representative
could expect to receive a stock commission of $343 as well as
$500 to $1,000 in options commissions from the above transactions.
Of course, if any of the calls were exercised, additional stock
commissions would be earned on the exercise and the repurchase
of Uojohn stock reauired to continue the covered options writing
oronram. Still further options charges would also accrue if, as
a result of a siqnificant move in the price of the stock, an existing
options position level was closed out and a new options position
established.

A sales guide of a national brokerage firm, which was distri-
buted to its registered representatives, pointed out the commission-
related incentives to salespersons for engaging their customers in
options trading. The guide stated:

306

[Ootions Writinq] can be the best revenue producer available to
fa registered representative] .

1. An account will generate 5-10% in conmissions
based on the money in the program i.e. if [the
customerl invests $25,000, [you] will receive
$1,250 to $2,500 a year in commissions.

2. If fyou] open one $25,000 account a week, you
will earn at the rate of $62,500 to $125,000
oer year .

3. If [youl margined all of them - you would be
earninq in the $125,000 to $250,000 category
- with only 50 accounts.

The same document included the statement:

Ootions are like an annuity. Once in operation,
they must do business several times each year. As
options come due, action must be taken... Many
reqistered representatives move money six to seven
times a year. Easy to see how [you] can generate
10% in commissions. (Emphasis added.)

The effects of the commission rate structure on the selling
of listed ootions underscore the need for adequate preparation
of options salespersons and for strong supervisory controls over
their sellinq activities.

4. Hiring and Termination Procedures

While the overall quality of the options sales force would be
enhanced, and its performance improved, if the testing, training
and suoervision of registered options salespersons were upgraded,
still another regulatory control must exist if the public is to

3o;

ue protectee trom tne unsatistactory performance ot salespersons.
DroKeraye nrms must desiyn — and implement — hinny ana employment
termination procedures capaoie ot identiiyiny and removing individuals
wnose on-tne-jOD pertonnance nas proved harmful to customers,
a. Hiring procedures

lb assure 'that persons applying tor positions as securities
salespersons have tne requisite character and capaoilities to service
customer neeas adequately, the NYbE requires that member firms "make
a tnorouyn inquiry into tne previous record and reputation of persons
wnom they contemplate employ my." Tne NYSE recommends tnat "[t]he
DacKyrouixi aixi reputation check should, whenever possiole, include
at least personal conversations with all employers dunny the previous
3 years ..." 6/ Tiie options exchanges liKewise require that their
members maxe a reasonaole investiyation ot the credentials of all
prospective employees. 7/

Virtually ail the firms in tne industry group sample, when queried
oy tne Options btuoy aoout their niring practices, responded that
tneir procedures included sane background review of every job applicant,
mciudiny a cnecK ot tne applicant's most recent employer and other
employers. However, the responses of most firms in the sample

_b/ Kuie 345, 2 NYbL Guide (CCH) 1i 2345.18.

7/ bee, e.y., Rule 340. U2, 2 AbE Guide (CCri) M 9390,

308

indicated that these firms did little more than comply with the
minimum requlatorv reauirements. And, while existing or former
customers are generally an excellent source of information concerning
a reqistered representative's performance, very few firms indicated
that thev contacted such customers as part of their background
check orocedures.

Even the limited checks required by the existing self -regulatory
rules, if followed, might be adequate to screen individuals seeking
nositions as reqistered representatives. In practice, however, partic-
ularlv with resoect to reqistered representatives already employed in
the industry, individuals who have patently unsatisfactory performance
records seem to be able to find employment at new firms if they have
records of venerating large commissions.

The breakdown in hiring controls appears to result from two
oervasive i.ndustrv practices. First, when asked by the hiring firm to
evaluate a reqistered representative's performance, the registered
representative's existing or previous employer does not always give
a candid assessment. The lack of candor may be explained in several
ways. Che reason suagested to the Options Study is that firms are
fearful of being subject to defamation lawsuits brought by registered
representatives who believe their careers have been damaged or

309

retarded bv their employers' unfair or untrue assessments of their
performance. Other reasons for lack of candor may be the desire of
a firm to rid itself quietly of an unsatisfactory salesperson, or the
concern bv the firm that lawsuits brouqht by unhappy customers of the
deoartinq registered representative miqht be aided by evidence that
the firm was aware of the registered representative's shortcomings.

The concern about defamation lawsuits is legitimate only insofar
as a firm's negative impressions of an employee cannot be substantiated
bv objective evidence. Thus, such evidence as written or oral customer
complaints and repeated (and recorded) violations of a firm's procedures
should, in most circumstances, enable a firm to avoid, or to counter
successfully, a charge of defamation. Only with regard to those employees
who violate no rules, or create no significant problems for customers,
but who simDly make an unfavorable "subjective" impression, is a firm
justified in withholding a negative report. The desire to be rid
of a or obi em salesperson, or the desire to avoid recompensing injured
customers — are not legitimate reasons to avoid candor in a self-
renulatory svstem designed to foster integrity of the marketplace and
to orotect public customers.

A second cause for the breakdown of hiring controls is that
the hirinq firm does not always heed warnings from the former employer
about a registered representative's unsatisfactory performance record.

310

The Options Study has reviewed several cases in which the quest

for the "biq oroducer" has caused a firm deliberately to dis-

reqard warnings. In one such case the firm knowingly hired two

salesmen who were under suspension by their former firm because

of serious unresolved customer problems. The salesmen were hired

over the objections of the firm's compliance officer who later

comolained that the salesmen had been "shoved down [his] throat."

In another case a registered representative, who had already been

suspended once by the Commission, passed throuqh two firms and

was hired by a third in a short period. His job application was

beinq considered not because he was a "big producer", but because

his brother was a "big producer," and the two together formed part

of the sales "package". In each firm the salesperson created

customer problems which the next employer firm knew about, or

would have known about if it had been warned by or had diliqently

asked the prior employers.

Two cases particularly illustrate how lack of candor by former

employers, and indifference to obvious problems by prospective employers,

have allowed options salespersons with unsatisfactory records to stay

in business:

Mr . B, a reputed "options expert," was employed at ten
brokeraqe firms from 1969 to 1978. Mr. B's employment was
terminated by major brokeraqe firms in 1975, 1976 and 1977.
In each case Mr. B left behind customers complaining of his
mistreatment of their options accounts. A self -regulatory

311

organization had taken disciplinary action against Mr. B in
both 1977 and 1978 on the basis of customer complaints.
Mr. B and each of the firms he was associated with in 1975,
1976 and 1977 have been sued by customers alleging fraud
and churning by Mr. B. A termination notice filed with
a self-regulatory organization by one of these firms was
false as was one application for employment completed by
Mr. B and filed with several self-regulatory organizations.
Mr. B is today the national sales manager of a registered
brokerage firm.

Mr. A's employment was terminated by a major brokerage
firm in 1975. The firm filed a termination notice which
stated that Mr. A had been the subject of several serious
customer complaints and that the brokerage firm believed
that Mr. A should not be rehired in the securities industry
because he had admitted doing unauthorized options trades
in customer accounts. Nonetheless, Mr. A was hired by
another major brokerage firm within two days even though
it was aware of the termination notice. Sixteen months
later, Mr. A left to join still a third firm as an options
salesman. At the third firm Mr. A filed an application
for employment which was false in that it denied any
former serious customer complaints or related conduct.
Within six months Mr. A was fired from the third brokerage
firm again for doing unauthorized options trades in
customer accounts.

b. Termination procedures

As discussed in Chapter VI, the NYSE, NASD and the options

exchanges all require member firms to file notices with them when

a salesperson leaves the firm for any reason. Notification forms

are provided which specify the reasons for termination. The reasons

generally fall into the following categories: (1) voluntary resignation;

(2) permitted to resign; (3) discharged; (4) deceased. The rules

require that member firms file the termination forms promptly

312

following termination, and, among other things, that the firms
disclose whether the terminated salesperson had been the subject
of any major customer complaints.

The notification requirements enable the self-regulatory organi-
zations to learn of possible misconduct which might reflect on the
qualifications of a registered representative to serve public customers.
For the notification requirements to serve useful purposes, the cir-
cumstances of employee termination must be stated accurately and
truthfully. The Options Study has seen indications, however, that
firms are not always truthful in their disclosures. For example:

A major broker-dealer firm fired a registered
representative and quietly settled the claims of
six complaining customers (paying more than $60,000
in claims, some options-related), before notifying
the various self-regulatory organizations of the
termination of the salesman involved. In the
notification forms, the firm answered "no" to
the question whether the salesman ever had been
the subject of any major complaint by a customer
of the firm.

After receiving written complaints about a sales-
man from at least three customers, and being aware that
others would be forthcoming, a firm discharged the
salesman. The firm answered "no" to the question on
the termination form which asked about customer
complaints.

Misrepresentations made by firms to each other or to self-
regulatory organizations seriously undermine an important premise
on which securities industry self-regulation is based — that brokerage

313

firms will deal honestly with each other and with the self-regulatory
organizations of which they are members, to assure that high standards
of conduct prevail in the industry. When such misrepresentations involve
employee misconduct, however, they seriously hinder self -regulatory
efforts to shield public customers from unsatisfactory registered
representatives. '

The Options Study believes that the recommendations in Chapter VI,
concerning the establishment of a central file containing, among other
information, all customer complaints received on particular registered
representatives, will greatly reduce the problems presently caused
by inaccurate and false termination notices. Nonetheless, the
self-regulatory organizations must protect the integrity of their
filing systems by bringing prompt disciplinary action against
those member firms and their employees who file false termination
or registration notices with them.

314

B. SUPERVISION OF ACCOUNTS

1 . Introduction

The intricacies associated with trading options are such that
strict supervision of each registered representative's activities
by his brokerage firm is essential to the protection of public
customers.

The self-regulatory organizations impose a duty on brokerage
firms to supervise the professional conduct of their employees, and
the Exchange Act provides for the imposition of sanctions upon any
broker aqe firm (or responsible employee) which fails in its supervisory
obliqations. _8/

The NASD's rule is the most explicit of the self -regulatory
organizations' rules in spelling out the obligations of its member
firms to supervise. In essence, member firms must have and use
written supervisory procedures, which a designated partner, officer
or office manager is responsible for carrying out in each "office
of supervisory jurisdiction." 9/ Further, in order to supervise
emplovees adeauatelv, member firms must: keep necessary records;

_8/ Section 15(b)(4)(E), Securities Exchange Act of 1934, 15 U.S.C.
78p(b) (1978).

_9/ An "office of supervisory jurisdiction" means any office, including
branch offices, desiqnated as directly responsible for the review
of the activities of registered representatives. NASD Rules of
Fair Practice, Art. Ill, § 27 ( f ) , NASD MANUAL (CCH) 11 2177.

315

review the activities of each of their offices, "including a periodic
examination of customer accounts, to detect and prevent irregularities
and abuses"; conduct an inspection, at least annually, of each office
which has supervisory jurisdiction; and review and initial all relevant
transactions and corresoondence of the firms1 registered representatives
who solicit or execute securities transactions. 10/

That these requirements apply to an "office of supervisory
iurisdiction" reflects the generally decentralized management
structure of manv brokerage firms that do business with the retail
oublic. Brokerage firms usually maintain a central or headquarters
office and various regional and branch offices, each under the super-
vision of a desiqnated manager. Tne Cptions Study has found that
customer-related problems often proliferate when a firm's supervisory
rxocedures do not adhere to the above rules and are not carried out
consistently frcm one office to the next. The problems are exacerbated
for options customers because current regulatory requirements do not assure
that supervisors knowledgeable in options will oversee the options business
of the firm, either in the central office or the branch offices.

10/ NASD Rules of Fair Practice, Art. Ill, § 27, NASD MANUAL (CCH) u 2177.

316

2. The RQP System

When the CBOE introduced trading in listed options, it recognized
that firms offering this new and complex product to the public ought
to have one person within the firm's management structure who possessed
some expertise about listed options. Accordingly, the CBOE required each
member firm to designate one officer or general partner to be the
firm's "Registered Options Principal" ("ROP") who would be responsible
for "the supervision... of all [the firm's retail] customer accounts"
insofar as those accounts traded options. 11/ The ROP would be required
to pass a qualifying examination in options.

The CBOE, however, did not fashion its rule to fit the decentralized
management structure of broker-dealer firms. Instead of requiring
that the options business of each sales office of a firm be supervised
by an ROP, it provided only for the designation of one home office
ROP. As other exchanges began to offer options, they, too, adopted
the ROP concept and required that their members designate an officer
or partner to be the firm's ROP. 12/ Like the CBOE, the other exchanges

11/ Rule 9.8, CBOE GUIDE (CCH) 11 2309. Later, when the number of
Registered Options Principals in each firm multiplied causing
some confusion as to precisely where responsibility for compliance
with exchange rules lay, CBOE revised its rules to reestablish
the concept of a single senior managerial officer with supervisory
responsibilities for the firm's overall options business. This
new "chief" options supervisor was dubbed "Senior Registered Options
Principal" ("SROP").

12/ See, e^. , Rule 920, 2 ASE GUIDE (CCH) 11 9720.

317

reouired that members designate only one options-qualified person
to supervise the firm's entire listed options business.

The ROP concept is the primary supervisory innovation developed
bv options exchanges to deal with increased problems of supervision of
options accounts. The ROP concept may eventually prove to be a sound
orinciole on which firms may build acceptable options supervisory
systems. The Options Study has found, however/ that as presently
desiqned and imnlemented , the ROP system is inadeauate to assure proper
suoervision of a broker-dealer firm's business in listed options. The
shortcomings of the present system are discussed below.
3. ROP Qualifications

The first problem with the ROP system of supervision is that con-
trols for Qualifying persons as ROPs historically have been inadequate.
In addition, the ROP examination itself has been deficient in certain
respects.

The current CBOE rules provide that "[p]ersons engaged in the
manaqe^ent of [a member firm's] business pertaining to Option Contracts'
may aualify to be desionated a registered options principal by passing
a written examination. 13/ The AMEX rule is virtually identical. 14/

13/ Rule 9.2, CBOE GUIDE (CCH) % 2302.
14/ Rule 920, 2 ASE GUIEE (CCH) 1| 9720.

40-940 O - 79 - 23

318

Persons who take the ROP examination may ask to be qualified by both
the CBOE and the AMEX or by either .

The examination is administered by the NASD under contract with
the options exchanges and it is given at local NASD test sites. The
maior weakness of the current examination is that the same version of
the test has been used numerous times so that specific test questions
may be known to many applicants before they take the examination. In
addition, the examination itself places too great an emphasis on the
mechanics of options trading and not enough on the supervision of
listed options tradinq. Approximately 90 percent of the current
candidates successfully pass the ROP examination.

While the current examination, although not perfect, serves as
a useful screening device for persons seeking certification as ROPs,
the ROP Qualification process did not always include a meaningful
examination requirement. Before 1975, candidates could qualify
for ROP certification simply by taking an open book examination
administered at their own brokerage firms. In 1975, when the AMEX
opened its facilities to options trading, and formalized ROP examination
procedures were introduced, those persons who already had taken the
ooen book test were exempted by the CBOE from the new examination
requirements. As a result, more than five hundred existing ROPs have
never been tested under controlled conditions. The failure of the
CBOE to reouire that all member firm ROPs pass stringent, properly

319

administered examinations has allowed persons with questionable
qualifications to become certified as ROPs. Not surprisingly, the '
Options Study has found cases where ROPs in critical compliance
positions in brokerage firms have exhibited only a limited knowledge
of options trading.

The growth of a strong ROP system would be beneficial for the
protection of public investors, since bona fide ROPs should have
enough expertise in options to enable them to supervise their firm's
options business. The value of the ROP system is substantially
reduced, however, if all ROPs are not required to successfully
complete an examination given under controlled conditions at neutral
testing sites. And, of course, for the examination to serve as a
true qualification test of options expertise, it should require
candidates to demonstrate substantial detailed knowledge of options
and an understanding of rules and regulations concerning options
trading. Accordingly, the Options Study recommends:

(1) THE REGISTERED OPTIONS PRINCIPAL QUALIFICATION
EXAMINATION SHOULD BE REVISED SUBSTANTIALLY TO
TEST ROP CANDIDATES' UNDERSTANDING OF SUPER-
VISORY REQUIREMENTS RELATING TO OPTIONS

AS WELL AS THEIR KNOWLEDGE OF OPTIONS:

(2) ALL REGISTERED OPTIONS PRINCIPALS SHOULD BE
REQUIRED TO SUCCESSFULLY COMPLETE THIS REVISED
VERSION OF THE EXAMINATION ADMINISTERED UNDER
CONTROLLED CONDITIONS.

4. Problems of Local Supervision

As noted above, the managerial structure of the brokerage industry
is largely decentralized. Most firms rely heavily on branch office
managers to supervise the conduct of registered representatives. The

320

arrival of listed options trading placed significant new responsibilities
on branch manaqers, many of whom were unfamiliar with options and
with the rules and regulations of the new options exchanges. Their
lack of preparation notwithstanding, these managers were required
to administer a new body of account approval, suitability and reporting
rules; they also were expected to understand the mechanics of listed
ootions trading and the various options strategies used by the registered
reDresentatives and customers in their branch offices.

Many branch managers have been unable to cope successfully with the
suoervisorv challenges posed by listed options trading. The Options
Study believes that several factors have contributed to their lack
of success as options supervisors. These factors include:

- the traininq requirements for branch managers, who need not be
qualified as ROPs under present options exchange rules;

- the orevailing methods of compensating branch managers, which
favor commission revenue production over careful supervision;

- overall lack of support for local supervisors from the firm's
central management.

a. Unqualified branch manaqers

As stated earlier, when trading began in listed options, the CBOE

required member firms to desiqnate one senior employee to become the

firm's oDtions suoervisor (the ROP) but stopped short of requiring

that each branch office of the member firm be managed by an ROP. It

follows that manv branch offices of broker-dealer firms are managed

321

by persons who know little about listed ootions regulations or trading.

For example, the Ctotions Study found managers who:

. tried to understand strategies employed by
reqistered representatives under their
supervision "only once" or "not at all"
because they did not know how to analyze
options trading activity or could not
recognize the strategies being employed;

claimed to review customer options information
forms onlv randomly and then not to determine
whether options trading was suitable for the
customer involved but rather "for [the manager's]
own education";

. did not know if their firms had criteria for
determining suitability of options transactions;

. did not know how many accounts in the branch office
were trading options or approved for options trading;

. did not know whether any accounts in the office
had been rejected for options trading and relied
upon the registered representatives in tne office
to know the manager's "thoughts" on a particular
options account approval question rather than seeking
approval in specific cases;

. did not know that customer account statements were
available in a microfiche file in their own branch
offices;

. had no written supervisory orocedures for overseeing
ootions trading in their offices.

In several of the instances set out above, public customers suffered
losses that would not have occurred with adequate supervision of the
activity of registered representatives selling options. Ihe lack of
traininq of the local supervisor contributed significantly to each
oroblem.

322

When a branch manager lacks the necessary expertise to supervise

the options business of his office, he sometimes delegates supervisory

authority to a subordinate manager or even to a registered representative

who holds himself out as an expert in listed options trading. The Options

Study has reviewed a number of cases in which such delegations have

led to confusion of responsibilities or, in effect, have resulted in

the very registered representative who is most in need of supervision

be inn permitted to supervise himself. For example:

. a manaqer allowed a registered representative to perform
the manager's daily compliance function of initialing
all trading tickets in the registered representative's
own discretionary accounts;

. a manager allowed registered representatives to approve
their own customer accounts for options trading;

. one registered representative was permitted to receive and
maintain all copies of customer account records;

in one situation, a branch manager and his subordinate each
claimed that the other was responsible for the conduct of
customer suitability reviews, which were never performed;

. one manager , who felt his background in sales had not prepared
him to supervise listed options trading, turned over all super-
visory authority to his operations manager, whom he then failed
to supervise;

one branch manager who knew of a growing number of customer
complaints against one registered representative selling
options and knew of other problems in the registered repre-
sentative's accounts, left on a two-week vacation without
givina his assistant manager any instructions concerning the
supervision of this registered representative.

In several of the above instances, public customers suffered harm because

inadequate supervision, resulting from inappropriate delegation of

authority, which allowed a registered representative to engage in improper

323

conduct. Problems of delegation have been particularly serious in
some satellite or sub-branch offices, where the primary supervisor is
not on the premises.

Some firms have come to recognize that proper supervision of
registered representatives1 options activities at the local level
requires the presence of an ROP with supervisory responsibilities in
each branch. More than 25 percent of the firms in the industry group
sample now require their branch office managers to be ROP-qualif ied,
and approximately 57 percent of all the branch managers of firms in the
industry group sample are ROP-qualif ied.

While the presence of an ROP-qualif ied supervisor in each brokerage

firm's sales office would not alleviate all the options sales practice

problems which result from a breakdown in supervision, such a requirement

would be a basis for sound supervision in the local sales office.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT RULES
TO REQUIRE THAT THE PRINCIPAL SUPERVISOR OF ANY
AND ALL OFFICES ACCEPTING OPTIONS TRANSACTIONS 3E
QUALIFIED AS AN ROP.

b. Compensation of local supervisors

Several conflicts of interest are inherent in the current system

of branch manager supervision. The most serious of these conflicts

spring from the method by which brokerage firms compensate branch

managers. Most brokerage firms compensate their branch managers, in

324

whole or in Dart, on the basis of the manager's own commission production
and on the orofitability of the office he manages. The following table
sets out the practices of the firms in the industry group sample with
reqard to compensating sales office managers.

COMPENSATION OF SALES OFFICE MANAGERS
Method of Compensation Percentage of Firms in Sample

Own commission production 38%

plus bonus or percentage
of office commission
oroduction

Salary olus own commission 21%

oroduction plus percentage
of office commission
oroduction

Salary and bonus 19%

Percentage of office 16%

commission Droduction

Profit participation above 3%

profit ouota for office

No response 3%

These results show that at least 78 percent of the firms in the
sample expect branch managers to look to either their own sales efforts,
or the sales commissions generated by the branches they manage (or a
combination of both) for some or all of their compensation. In addition,
91 percent of the industry group sample told the Options Study that
thev allow local sales office supervisors to service their own customer

325

accounts. These conditions offer temptation for a local manager to favor
the commission production of his office or of his own sales efforts
over the reouirements of proper supervision.

It is eoually apparent that when the branch manager spends much
of his working day servicing his own accounts, he has less time for
supervision of the activities of other salespersons and, particularly,
for the detailed financial analyses sometimes required to oversee
adeouatelv customer options trading.

The incentive provided to a local manager to favor commission production

rather than supervision is evident in the following testimony of a registered

representative regarding his branch manager's attitude toward supervising

a verv active customer account :

FXCERPT FROM TESTIMONY OF AN OPTIONS SALESMAN - November 10, 1977

LAWYER: Now, you mentioned that you discussed [this investor's]

option account with [your supervisors]...

Do you recall anything that [your branch manager] ever
told you in connection with the commissions that [this
investor] was generating?

SALESMAN:

Not really, no, just enjoy it while it lasts.

LAWYER: What did you understand [the branch manager] to mean

when he said to you, "Enjoy it while it lasts?"

326

SALESMAN: That eventually, you know, he'll probably move on to
another broker aqe firm, you know, blow himself out
of the water .

LAWYER: Was there any discussion of what could be done to

help [the investor]?

SALESMAN: Not to help, no. [The branch manager] just said that,
you know, make sure that we get the money. Okay?
Keep him posted. And I think I remember [the operations
manager] mentioning that this account may have to be
restricted because of the fact that he had now had
three purchases which he had not paid for in cash, but
had sold , you know, after the purchase , days later ,
which first was like a free riding, and after three
of those things, the account is to be restricted.
... And then [the branch manager's] comment was that
'we will never restrict the account.'

LAWYER: Did he say why?

SALESMAN: No. It was understood. There was a big — you know,
a big revenue machine .

In nearly every significant case of fraud encountered by the Options

Study, there has been a local breakdown of supervision caused, at least

in part, by the conflict of interest engendered by a manager's own

interest in commission ©reduction and his responsibilities as a supervisor

The most serious manifestation of this conflict is the tendency of

local managers to pamper large commission producers even to the point

of iqnoring clear indications that the "producer" is not properly

servicing his customers' accounts. One branch manager testified about

327

how delighted he was to have two options salesmen who were "high producer;
in his employ. He actively recruited customer accounts for them, even
thouqh he had stronq indications that both salesmen had caused and
were causing serious problems in their handling of customer accounts.

The financial inducements to humor the large commission
producer are reinforced by the manager's awareness that regis-
tered representatives generally are free to go where they please and
to choose a firm where supervisory conditions are favorable to their
ways of doing business. Since a registered representative who leaves
a firm often succeeds in taking with him many of his customers and
the commission revenue production of those accounts, a manager whose
own livelihood depends on such revenues may be disinclined toward
vinorouslv "suoervisinq" registered representatives whose activities
generate substantial commissions.

This concern, not to lose a "big producer," is reflected in the

following warning memorandum concerning the second largest options

revenue commission producer in a major brokerage firm. In this

memorandum, which was not heeded, the chief compliance officer of

the firm told top management:

I asked [the branch manager] if he reviewed the
— monthly statements that were sent to him
and he said "Yes, I just sign them and pray."
Be has made no effort to understand the activity

328

in [this registered representative's] accounts.
He is clearly afraid that if he questions [this
registered representative] , [the registered
representative] will resign and go to another
firm.

Some manaqers have designated large commission producers "options co-
ordinators" or "options oroduct leaders", apparently in order to placate
them, and then have failed to supervise their activities. Che local
suDervisor refused to believe the problems that continually emerged
concerning a team of registered representatives who sold exotic options
orograms, telling customers who complained that their complaints had
no substance because "there would be red lights flashing and warning
bells going off all over the place" if their complaints were true.

The problems caused by the effects upon sales office managers of
the ccmnensation structure are very difficult to control by regulation.
The Qotions Study believes, however, that a firm's overall policies
concerninq its sales practices set the tone and the standards by which
all the firm's employees conduct themselves. If the management of
the firm makes clear that a branch's performance will be measured not
-just by commission production, but by customer satisfaction and fair
treatment, the method by which branch managers are compensated would
be a less serious impediment to sound supervision than it now appears
to be.

c. Attitude of the Broker-Dealer Firm Toward Supervision

The Options Study has found that the attitude of a brokerage
firm toward supervision either reinforces sound supervisory procedures

329

or, if misdirected, can seriously weaken the resolve of branch managers
to suoervise. She Options Study came across several cases in which
prevail inq attitudes within the firm undermined a branch manager's
efforts to control a "biq producer" and permitted the misconduct of
the reqistered representative to continus. In one case, where the branch
manaqer was aware of compliance problems concerning one team of options
salesmen, he was also confronted by a letter from a regional sales
manaqer of the firm to one of the team members congratulating him
for recent production figures and expressing appreciation for his
"fine efforts." In another case, where a branch manager expressed
concern about the activities of two options producers to management
at the heme office, his warnings were ignored because of the home
office's "high reqard" for these large commission revenue producers.

Two case studies reviewed by the Options Study particularly
illustrate how a firm's attitude toward the supervision of a registered
representative who produces larqe commissions may permit serious mis-
conduct to qo unchecked.
CASE A

For more than six months, a large commission producing registered
representative was nominally supervised by a vice president of a major
brokerage firm who was located at a different address than the registered
representative. The registered representative was given office space
adjacent to special communications equipment, his own telex terminals

330

and his own alphanumeric code. Treated as the functional equivalent

of an entire branch office, this registered representative, not his

supervisor, was sent the supervisor's copy of customer statements

and account analyses.

After several months of extremely active trading involving

ootions in the registered representative's accounts, the vice president

assianed to "supervise" the salesman warned his own superiors:

[This registerered representative] cannot be effectively
supervised from [his current location] ....

Althouqh our basic gut feeling about [this registered
representative] is good, his entire business is concentrated
in [several] accounts, and there is no doubt in our
minds [he] will bend over backwards to give these
[several] accounts whatever they want. As a result,
our exposure is considerable....

We have no papers as of yet for [a major] account,
but understand that new account papers are on the
wav ....

[The registered representative's] business is so large and
complex, that daily on-the-spot supervision must be conducted.

The same memorandum then set forth a discussion of the profitability

of the reqistered representative's activities for the year to date,

annualizing figures to determine a "gross production" of $650,000

and an approximate "profit to the office" of $150,000. The memorandum

concluded :

1. Fbr the time being at least, we want [this registered
representative] .

2. We want him only if we can control him.

3. We must keep him happy..."

331

Two months later, the same vice president again warned his

superiors about this same registered representative:

... my conclusion — that [this registered representative]
cannot be effectively supervised under present conditions
has not changed, and is based upon the following observa-
tions:

[This registered representative] needs the brokerage
journals, daily transaction analyses, commission sheets,
two sets of customer confirms, statements, etc., to
effectively conduct his business. For that reason he
will not release any of the foregoing, and since duplicates
are not available, it's an impossible job to determine what
he does over there (and, for that matter, how he does it)....

DesDite these warnings, no effective steps were undertaken to

supervise this registered representative's activities for another

three months. Curing this period, the registered representative

was able to perpetrate a complex fraud on his options customers to

whom his brokerage firm eventually paid several million dollars to

settle lawsuits.

CASE B

In March 1978, Mr. X was promoted to be manager and resident

supervisor of a branch office of a major brokerage firm. About this

time, Mr. X, one of the largest options commission producers in the

firm, was featured by a national financial columnist as an options

expert whose exotic options strategies had returned up to 20 percent

on eouity for pleased options customers during the just past year. The

article went on to set out some of Mr. X's recommended options trades.

Unknown to readers of this column and to almost all of Mr . X's own

options customers, Mr. X's options accounts were actually in disarray as

332

a result of excessive trading and Mr. X's mismanagement. Ultimately,
several of Mr. X's customers sued him and his employer for fraud
and recovered substantial judgments.

Mr. X had been made sales manager and then a branch manager of the
firm even thouqh he had proved to be a constant supervision problem.
Gomoliance oersonnel had warned Mr. X of excessive trading in his
customer accounts, had asked in vain that he inform his customers
of their account eauity, and had requested, without success, that he
tell the firm how many of his options accounts were discretionary.
These problems had also been brought to the attention of senior
management of the firm.

The top manaqement of the firm, concerned that strict supervision
over Mr . X might drive him out of the firm, had ignored repeated warnings
about bis performance from the compliance office and instead attempted
to resolve amicably the problems which Mr. X had caused for his super-
visors. For more than a year, the firm gently attempted to bring Mr.
X and his customer options accounts under supervisory control. Management
finallv resolved the problem of supervising Mr. X by promoting him
to branch manager. In this new position, Mr. X had supervisory control
over his own activities and over the activities of several younger
salesmen whose sales efforts were almost exclusively in listed options.
At least one of these salesmen was subsequently the subject of options-
related customer complaints.

333

The Options Study believes that sound selling practices require

top management of a brokerage firm to be committed to a program of

effective supervision and to demonstrate its support for such a program.

A detailed program of supervision which incorporates the recommendations

in this selling practices chapter as minimum standards could form the basis

of an effective supervisory program. Accordingly, the Options Study

recommends :

THE SELF-REGULATORY ORGANIZATIONS SHOULD DEVISE A
UNIFORM DETAILED PROGRAM FOR SUPERVISION OF OPTIONS
TRADING WITHIN MEMBER FIRMS WHICH WOULD ESTABLISH
MINIMUM SUPERVISORY STANDARDS AND PROCEDURES
AND WHICH WOULD ADDRESS THE ISSUES RAISED IN, AND
INCORPORATE THE RECOMMENDATIONS OF, THIS CHAPTER
AMONG THOSE STANDARDS AND PROCEDURES.

5. Home Office Supervision

For a broker-dealer firm's overall program of supervision to be
acceptable, the headquarters office as well as the branch offices must
have personnel who can oversee and support the work of supervisors at
the sales offices. Certain types of options-related compliance matters,
such as periodic surveillance of customer options transactions and the
overview of options trading in a branch, are more appropriately performed
by home office personnel properly qualified in options.

As already noted, the rules of the options exchanges require that
member firms designate a principal or "Senior" Registered Options
Principal ("SROP"), who is an officer or general partner of the firm,
to be responsible for the supervision of options customer accounts.

40-940 O - 79 - 24

334

The central, indeed unique, role assigned to the SROP in a firm's
or oar am of ootions compliance requires that the person designated
as SROP not be given conflicting duties and responsibilities. Yet,
many firms appear to regard SROPs more as sales promotion managers
than as compliance officers. Well over half the firms in the industry
nrouo sample responded on the Options Study questionnaire that they
assign to their SROP the job of heading the firm's options marketing
program (56 percent). More than two-thirds of the firms in the sample
assian to their SROP some selling function (68 percent).

The distraction of sales promotion responsibilities can prevent
an SROP from focusing his complete attention on supervision of the
firm's options activities. Moreover, if, as options sales manager,
he is competina with other "product managers" (commodities, annuities,
etc.), for the attention of registered representatives, he, like his
branch manager counterpart, may be more interested in sales figures
than in sound sales practices.

The co-opting of the SROP for sales promotion purposes, however,
would not be of particular concern if someone else of stature within the
firm, who had demonstrated options expertise, such as an ROP-qualified
compliance officer, were assigned significant supervisory responsi-
bilities over options accounts. Ifewever , in almost half of the firms
surveyed by the Options Study, the SROP was not the firm's chief compliance
officer, nor was the firm's chief compliance officer ROP-qualified.

335

In more than one quarter of the industry group sample, no senior official

of the firm with options expertise had primary options compliance

responsibilities, since the SROP was involved in his firm's options

marketing effort, and the chief compliance officer was not ROP-qualif ied.

In many of these firms, not a single home office compliance employee

was ROP-qualif ied.

Having ROP-qualif ied individuals supervise options accounts at

the home office level is less important if the firm's branch office

managers are required to be ROPs. As noted above, however, only a

little more than one quarter of the firms in the industry group sample

now require their branch office managers to be so qualified. And almost

one quarter of the responding firms (1) do not require branch office

managers to be ROP-qualif ied; (2) do not have any ROP-qualif ied home

office compliance personnel; and (3) assign to their SROP significant

sales functions. To ensure sound options selling practices by the

firm and its registered representatives, a policy-level compliance

officer is needed at a firm's headquarters office to lead the

program of supervising — not promoting — the firm's options

bus iness .

Accordingly, the Options Study recommends:

THE RULES OF THE SELF-REGULATORY ORGANIZATIONS
SHOULD BE AMENDED TO REQUIRE THAT BROKERAGE FIRMS
ASSIGN AT LEAST ONE HIGH RANKING PERSON WHO IS
ROP-QUALIFIED TO PERFORM, OR TO DIRECTLY SUPERVISE,
HOME OFFICE COMPLIANCE PROCEDURES RELATING TO OPTIONS.
THE RULES SHOULD PROVIDE THAT, ABSENT A CLEAR
SHOWING OF COMPELLING CIRCUMSTANCES, THIS PERSON
HAVE NO SALES FUNCTIONS, DIRECT OR INDIRECT,
RELATING TO OPTIONS OR OTHERWISE.

336

C. SUITABILITY

1. Introduction

Durinq 1978, the Commission charged a major broker-dealer firm and
several of its employees with violations of the anti-fraud provisions
of the Federal securities laws in connection with the options selling
activities of several- of the firm's registered representatives. One
team of registered representatives from this firm had persuaded its
customers to engage in a program consisting of large-scale writing of
uncovered options that were near-the-money, an extremely risky form of
ootions trading activity. As outlined below, many of these customers
did not have the financial means, sophistication, or investment objectives
to justify exoosure of a substantial portion of their assets to an uncovered
writing program:

Customer A — a retired minister in his early 80 's. He had an
annual income of between $10,000 and $25,000 and a net worth of
$25,000 to $50,000. His recorded investment objectives were
dividend income and "additional income from sale of uncovered
ootions." There was evidence that he was mentally unstable.
He invested $30,500 and lost $23,700 in six weeks.

Customer B — an unemployed widow. She had an annual income of
under $10,000 and a net worth of approximately $85,000, and
relied on the expected income from her options account to
meet her living expenses. Her prior investment experience
consisted of mutual fund purchases, blue chip stocks, and a
small amount of covered writing. She placed stock worth
$22,000 into the account and lost $19,000 in six months.

Customer C — a retired post office worker. He had an annual
income of approximately $10,500 and a net worth of less than
$50,000. He invested $16,700 and lost $8,600 in three weeks.

Customer D — a computer designer . He had an annual income of
$25,000 and less than $25,000 in estimated net worth and lost
nearly all of his $10,770 options investment.

337

. Customer E — a colleqe student. She needed income fron her
investment to complete her colleqe education. She had a joint
account with her father, a marketing representative, whose job
took him out of the country for extended periods of time. The
nair suffered a total loss of their $25,000 joint account in one
and a half months.

. Customer F — a customer, with a severe heart condition whose
objectives and investment experience were conservative. He
transferred into his options account a portfolio consisting
of investments in conservative stocks and an income-oriented
mutual fund. The customer lost $9,000 of the $14,000 invested
in two months.

These examples illustrate a major regulatory concern which has
develoDed from listed options trading — options trading is unsuitable
for manv of the oublic customers who engage in it. The Options Study
found, throuahout its investigation, numerous customers who had been
solicited for listed options trading even though, by any reasonable
standards, they had neither the sophistication to understand, nor the
financial resources to bear, the risks they were undertaking.

None of the customers in the cases above satisfied the suitability
standards of the self-regulatory organizations with regard to uncovered
oDtions trading; none of them even satisfied the brokerage firm's
own minimum liouid asset and annual income requirements for customers
who engaae in risky options trading. The firm's general warning to
its registered representatives against involving widows, senior citizens,
and other classes of conservative investors in the more speculative
tyoes of options strategies was to no avail.

338

A number of factors contributed to the failure of this brokerage
firm to protect the interests of its customers. The registered repre-
sentatives involved were untrained, unscrupulous and unsupervised;
the firm overemphasized commission revenue production; the local
and home office supervisors were either unwilling or unable to
suoervise oroperly registered representatives selling options.
These problems could not have occurred without serious flaws in
the firm's suitability control procedures.

2. The Suitability Doctrine

The doctrine that a securities recommendation must not be unsuitable
for a customer in liqht of his financial resources and investment
obiectives is a key element in a broker-dealer 's obligation to deal
fairly with its customers. The doctrine requires that a broker-dealer
and its registered representatives recommend for the firm's customers
only those securities transactions which they reasonably believe are
suitable in light of the customer's financial situation and needs. 15/
The suitability reauirement does not attempt to make a registered
representative, or the brokerage firm for which he works, an insurer
of favorable investment performance. It does, however, obligate the
brokeraae firm and registered representative to make sure that any
recommendations made are done so with the customer's interests and
characteristics uppermost in mind. As such, the doctrine, and the

15/ See generally R. MUNDHEIM, Professional Responsibility of Broker-
Dealers: The Suitability Doctrine, 1965 DUKE L.J. 445 (1965)
[hereinafter cited as MtNDHEIM] ; N. WOLFSON, R. PHILLIPS & T. RUSSO,
REGULATION OF BROKERS, DEALERS AND SECURITIES MARKETS (1977), 1| 2.08
[hereinafter cited as WOLFSON] .

339

self-requlatory organization rules which codify it, are meant to serve
as a fundamental protection for customers who rely on the judgment and
exDertise of their brokerage firms and their registered representatives.

Manv customers have difficulty comprehending the risks involved
in ontions tradinq, and, out of necessity, develop a total dependence
upon the advice, of their reqistered representatives. In these circum-
stances, where options customers frequently cannot make informed
decisions concernina their own accounts, the responsibility of registered
representatives to assure that recommendations made to customers are
suitable is all the more meaningful.

a. Traditional concepts of suitability

The suitability doctrine originally developed as an ethical standard

of business conduct and was first set down in the 1930s as a guideline

to the NASD Rules of Fair Practice. As now incorporated into the

NASD rules, it states:

[I]n recommending to a customer the purchase, sale or exchange
of any security, a [broker-dealer] member shall have reasonable
qrounds for believinq that the recommendation is suitable for
such customer upon the basis of the facts, if any, disclosed by
such customer as to his other security holdings and as to his
financial situation and needs. 16/ (Bmphasis added.)

The NASD suitability rule, therefore, requires that member firms have a

reasonable basis for believing that a recommendation is suitable, but

does not recuire specifically that firms inquire into the customer's

financial circumstances and investment objectives. 17/

16/ NASD Rules of Fair Practice, Art. Ill, § 2, NASD MANUAL (OCH) 1| 2152.

17/ Ibid. , "Policy of the Board of Governors", (discusses NASD policies
relating to this rule).

340

The NYSE and AMEX have not adopted rules which directly address
suitability of recommendations to buy or sell listed stocks or bonds.
However , both exchanges do impose on member firms a duty to use "due
diliqence to learn the essential facts relative to every customer." 18/
Althouqh this requirement, to "know your customer", might have been
desiqned oriainally to protect member firms against poor credit risks,
it has been interpreted over the years to serve also as protection for
customers against unsuitable recommendations. 19/

In 1967, the Commission adopted its own suitablity rule, applicable

to broker aae firms which are not members of the NASD or of any national

exchanqe. Known as the "SECO" suitability rule, it provides that:

Every nonmember broker or dealer and every associated
person who recommends to a customer the purchase, sale
or exchange of any security shall have reasonable grounds
to believe that the recommendation is not unsuitable for
such customer on the basis of information furnished by
such customer after reasonable inquiry concerning the
customer's investment objectives, financial situation
and needs, and any other information known by such broker
or dealer or associated person. (Emphasis added.) 20/

Unlike the NASD rule, the Commisssion's rule imposes on brokerage firms

a soecific affirmative duty to inquire into a customer's circumstances.

18/ Rule 405, 2 NYSE GUIDE (OCH) 11 2405; Rule 411, 2 ASE GUIDE (CCH)
II 9431.

19/ WOLFSON, at \\ 2.08[1]; MJNDHEIM, at 451 n.14 and 463 n.54.

20/ Securities Exchanqe Act Rule 15bl0-3, 17 C.F.R. § 240.15bl0-3 (1977)

341

b. Suitability developed for listed options

When the CBOE was established in 1973, it adopted a suitability rule
which included the traditional standards of suitability and parallelled
the Commission's own rule. Therefore, like the Commission's rule, the
CBOE rule imposes on brokerage firms a specific affirmative duty to
conduct reasonable inquiry into a customer's circumstances and to have
reasonable qrounds for believing that a recommendation is not unsuitable
for the customer .

In addition, the CBOE rule included additional and more stringent
suitability standards to recognize the potentially greater risks inherent
in uncovered call writing transactions. When the rule was amended in 1977
to include outs, these standards were also made applicable to recommenda-
tions for put writing transactions. These additional requirements provide
that:

[A] recommendation to a customer of [writing a put or an
uncovered] call ootion contract, shall be deemed un-
suitable for the customer unless, upon the information
furnished by the customer , the person making the recom-
mendation has a reasonable basis for believing

that the customer has such knowledge and experience in
financial matters that he may reasonably be expected to
be capable of evaluating the risks of such transaction,
and such financial capability as to be able to carry such
position in the option contract. 21/ (Emphasis added.)

The most significant difference between this standard and the tradi-
tional standard applicable to supposedly less risky options transactions

21/ Rule 9.9, CBOE GUIDE (CCH) 1| 2309.

342

is that this new standard requires that the firm have a reasonable
basis for believing that the customer is sophisticated enough in
financial matters to understand the risks of uncovered call writing
and put writing strategies. The rule relating to other options
strateqies requires no such finding.

Other self -regulatory organizations have adopted suitability
rules similar to the CBOE's, both with respect to general options
trading and to the more risky uncovered call writing and put writing
strategies. 22/

Tne Options Study believes that the current suitability standards

applicable to options transactions should be strengthened in the

following ways:

(1) A Finding that the Customer is Capable of Evaluating
the Risks of Options Transactions

The current options prospectus states on the cover page in

bold- face type:

Both the purchase and writing of Options involve
a high degree of risk and are not suitable for many
investors. Such transactions should be entered into
only by investors who have read and understand this

22/ Rule 923, 2 ASE GUIDE (CCH) 1| 9723; Art. XLVM, Rule 5, MSE
GUIDE (CCH) 1(2115; Rule X, Sec. 18(c), PSE GUIDE (CCH)
11 4993; Rule 1026, PHLX GUIDE 11 3026. Unlike the CBOE rule,
the suitability standards of the other options exchanges
apply to all transactions in put or uncovered call writing,
whether or not recommended. Tnis means that the firm must
refuse to effect any unsolicited transaction in either put
or uncovered call writing unless the firm has a reasonable
basis for a suitability determination.

343

prospectus and, in particular, who understand the
nature and extent of their rights and obligations
and are aware of the risks involved. (Emphasis added.)

As discussed above, the options exchanges do not require that a

broker-dealer recommend ing options transactions to a customer have

a reasonable basis for believing that the customer understands the

risks of the recommended transactions, except when the particular

recommendation or transaction is to write uncovered calls or to write

Dut ootions.

The Ootions Study believes that a customer should be made aware,

on an on-going basis, of the risks of any and all options transactions

undertaken bv the customer and that a brokerage firm should not be

oermittei to recommend any options transaction to a customer unless

the firm reasonably believes that the customer is capable of both

evaluating the risks and bearing the financial burden of those risks.

Accordinaly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD REVISE THEIR
OPTIONS CUSTOMER SUITABILITY RULES TO PROHIBIT A BROKER-
DEALER FROM RECOMMENDING ANY OPENING OPTIONS TRANSACTIONS
TO A CUSTOMER UNLESS THE BROKER-DEALER HAS A REASONABLE
BASIS FOR BELIEVING THE CUSTOMER IS ABLE TO EVALUATE
THE RISKS OF THE PARTICULAR RECOMMENDED TRANSACTION
AND IS FINANCIALLY ABLE TO BEAR THE RISKS OF THE RECOMMENDED
POSITIONS.

(2) An Affirmative Requirement to Obtain Suitability
Information Before Recommendations are Made

A broker-dealer 's duty of "reasonable inquiry" under the suitability

rules requires that the firms at least ask the customer for suitability

information. If a customer refuses to furnish this information, the

344

ririn must, nevertheless, nave " reasonable y rounds" on wnicn to base a
suitability uetenuination.'t

Tne CdOE yuiaelines max.e clear tnat " [mjakiny a recommendation
witnout Knowmy tne customer's essential tacts or otner inionnation
win result in tne recommendation Deiny unsuitable. " 23/ However,
tnese yuidennes do penult options transactions to be recommended
to a customer wno reiuses to turnisn suitability lntormation, pro-
vided tne rinu nas otner lntormation mdicatiny tnat tne recaiimended
transaction is not unsuitable tor the customer.

Estimating suitability lntormation tor a customer wno retuses
to turnisn tnis intonation can result in the same problems that
occur wnen a reyistered representative tails to inquire into a
customer's bacKyrouna. Unless sutticiently comprehensive customer
mtomiation is actually ootained, suitability detenninations
cannot oe maae.

Accordingly, to clarity and strenythen tirms' obligations to

outain suitaoility inrormation tor customers, tne Options Study

recommends :

THE RULES OF THE SELE-REGULATORY ORGANIZATIONS

SHOULD dE Ai-iENDED 'lO PROHIBIT FIRMS FROM REGOM-

inENDlNG OPENING OPi'IONS TRANSACTIONS ID ANY CUSTOMER WHO

16/ CbOE Educational Circular ffb, at 10.

x tor a more detailed discussion of tne amount of information

necessary to torm reasonable yrounds for a suitability detennation ,
see p. tz below.

345

REFUSES TO PROVIDE INFORMATION, AND FOR WHOM THE
FIRM? DO NOT OTHERWISE HAVE INDEPENDENTLY VERIFIED
INFORMATION SUFFICIENT FOR THE SUITABILITY
DETERMINATION.

c. Account opening rules

The existing suitability rules require that a brokerage firm
ask its customers for certain information and use the information
obtained, alonq with any other information known about the customer,
in determining whether recommended options transactions are suitable
for that customer . In an attempt to assure that such information is
obtained and used, all the options exchanges have adopted rules which
reouire that before a customer is permitted to trade options, his
brokeraqe firm must make an initial determination that listed options
tradinq is not unsuitable for him.

The CBOE's "know your customer" rule is a typical options exchange

account opening rule. It requires that suitability information be

obtained, recorded, and used by a brokerage firm in determining

whether to aDDrove the account for options trading:

In approving a customer's account for options transactions,
a member organization shall exercise due diligence to learn
the essential facts as to the customer , his investment
objectives, financial situation and needs. A record of this
information shall be maintained by the member organization
and, based upon such information, a Registered Options
Principal who is an officer or partner of the member organi-
zation shall approve in writing the customer's account for
options transactions .... 24 /

24/ Rule 9.7(b), CBOE GUIDE (CCH) 1! 2307.

346

Other self-requlatory organizations have adopted similar account
opening rules. 25/

d. Summary

In conjunction with account opening requirements, current suitability
standards aoplicable to a firm's initial determination of the general
suitability of oDtions trading for a customer, and of specific trans-
actions after the customer is approved for options trading, can be
summarized as follows:

(1) The brokerage firm qenerally must acquire, use and maintain
a current record of information regarding the customer's background,
financial resources and investment objectives.

(2) Using the information thus acquired, the brokerage firm must
make three determinations:

(a) does the customer have sufficient financial resources to
bear the risks of a recommended transaction;

(b) are the risks of a recommended transaction appropriate in
liqht of the customer's investment objectives; and

(c) with regard to recommendations of put or uncovered call
writing transactions, is the customer sufficiently sophisticated

to enable him to corner ehend the risks involved in such transactions.*

25/ Rule 921, 2 ASE GUIDE (OCH) 11 9721; Art XLVIII, Rule 3, MSE GUIDE
(CCH) 11 2113; Rule X, Sec. 18(b), PSE GUIDE (CCH) 1| 4993; Rule
1024(b), IHLX GUIDE (OCH) H 3204.

* As noted above, the Options Study believes this requirement should
be made applicable to all recommended transactions.

347

The Options Study has found violations of these standards throughout
the industry.

3. Acquisition of Information
a. Accuracy

A firm's first step in making a proper suitability determination
is to obtain the- required information from its customers. This information
is then usually transferred to an account information form and retained
by the firm.

Althouqh the reouirement that firms obtain this information is
explicit in the self-regulatory rules, firms nevertheless evade it
in several ways. First, a majority of the firms surveyed by the
Ootions Study oermit registered representatives to estimate customers'
financial suitability information when opening accounts for options
tradinq, rather than insisting that the registered representative
obtain exact information from his customers. Second, when existing
securities accounts are converted to options trading, many firms
have a practice of simply transferring the information on the customer's
or in in al, and often outdated, account opening card to the new account
aDoroval form for options. Finally, registered representatives may
deliberately overestimate their customers' financial status in order
to gain from their supervisors approval of those accounts for options
tradinq .

348

As a result of these practices, it is not uncommon to find inaccurate
suitability information about a customer contained in the files of
broker-dealer firms. The Options Study found one situation in which
a reqistered representative had estimated his customer's annual income
at $15,000 to $20,000 and her net worth at $70,000, when in fact she
earned $12,000 and her entire net worth consisted of the $20,000 equity
in her home. In another case, one set of firm records showed a customer's
net worth as $250,000 while another set of the firm's documents showed
the same customer's net worth as only $30,000.

One reqistered representative testified that she had estimated a
client's income to be substantially hiqher than it actually was and
that, had she known the customer's true financial situation, she would
have urqed a more conservative investment approach. Another registered
representative admitted that he never asked one of his customers for the
customer's net worth but instead made a suitability determination based
on a "first impression" of the customer's business knowledge, dress,
and sophistication in discussing securities and strategies. Unknown
to the registered representative, this customer was a retired medical
consultant with limited resources and an annual income of only $6,000
per year. The registered representative also mistakenly assumed the
customer's investment objective to be capital gains instead of income.

Inaccurate suitability information in a firm's files prevents a
firm's supervisory personnel from fulfilling their responsibility to
make reasoned determinations of the suitability of options trading for

349

the firm's customers qenerally and for particular options transactions.

As a conseouence, customers can become involved in options transactions

totally unsuitable to their means. A sample of such cases includes:

. an 18 year old student away at college who was allowed to trade
listed ootions and lost approximately $2,200 of tuition money.
This student had been turned down for options trading in his
hometown office of the same firm by a registered represent-
ative who handled his parents' securities account;

. a welfare recipient who was engaged in a strategy of selling calls
covered only in oart by warrants on the underlying stock;

. a widowed, retired school teacher who was allowed to engage
in advanced options strategies from which she lost one half
of her life savings.

Manv customers never see the financial and other data which

sunoosedly form the "reasonable basis" for a determination of their

options suitability. Inaccurate information about options customers

might be corrected if all firms enabled customers to verify personally

their account information. Although some firms either: (1) send a

coov of the suitability information to the customer for his verification,

or (2) check with a credit agency, bank or other credit reference

in order to determine the veracity of customer suitability information,

many firms surveyed by the Options Study make no such attempt.

Tb correct this situation, the State of Wisconsin has required

that firms furnish every customer with a conformed copy of all agreements

between the firm and the customer and with a copy of the prescribed

customer information form. 26/ In order to conform with the V\/isconsin

26/ Wise. Admin. Code § 4.05(7).

40-940 O - 79 - 25

350

statutes, several brokerage firms send a copy of the customer information
forms to their customers in Wisconsin, but have chosen not to expand
this practice to customers located in other states.

The Options Study believes all firms should be required to verify
the accuracy of such information by sending a copy of the completed
form to the options customer. It is important, however , that procedures
for verification not be regarded as a means for lessening the broker-
dealer's responsibility to obtain accurate and comprehensive suitability
information.

In an effort to imrrove the accuracy of recorded suitability

information, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD MEND
THEIR OPTIONS ACCOUNT OPENING RULES TO REQUIRE TEAT
(1) THE MANAGEMENT OF EACH FIRM SEND TO EVERY NEW
OPTIONS CUSTOMER FOR HIS VERIFICATION A COPY OF
THE FORM CONTAINING THE CUSTOMER'S SUITABILITY
INFORMATION; AND (2) THE SOURCE (S) OF CUSTOMER
SUITABILITY INFORMATION, INCLUDING THE BASIS
FOR ANY ESTIMATED FIGURES, BE RECORDED ON THE
CUSTOMER INFORMATION FORMS.

b. Sufficiency

Not only is a firm's information about its customers sometimes

inaccurate, it can also be severely lacking in content. Although

none of the options suitability rules specify the amount of information

necessary to form a reasonable basis for a suitability determination,

"Educational Circular #6" prepared by the CBOE suggests the type of

customer information which a firm should record in writing:

351

Inauiry should attemot to determine pertinent facts
about the customer . Some facts which may be considered
pertinent are the client's marital status, dependents,
occupation, maior sources of income, investment objec-
tives, net worth, investment experience, and ability
to understand and evaluate the risks of options trans-
actions. A written record of the essential facts must
be maintained by the firm 27/

Attached to the CBOE circular is a checklist of information that the firm
miqht wish to obtain during its customer inauiry, such as occupation;
net worth; dependents; annual income; past investment experiences in both
ODtions and other securities ( specif iying size, frequency of transactions,
type of transactions, and years of experience); and investment objectives.

The AMEX publishes a similar checklist which, in addition to the infor-
mation reouired by the OBOE, suggests that a firm distinguish between a
customer's income from employment and his income from other sources;
identify whether the customer rents or owns his own home; and obtain the
customer's net worth exclusive of family residence, as well as his liquid
net worth, insurance, and previous and current brokerage accounts (including
type and deqree of activity). 28/ The AMEX guidelines require, in
addition, that the customer's refusal to furnish all the information
necessarv for account approval be noted on the customer's account form. 29/

27/ CBOE Educational Circular #6, at 2.

28/ AMERICAN STOCK EXCHANGE, ATTACHMENT TO REGULATORY GUIDELINES FOR
CONDUCTING A PUBLIC BUSINESS IN AMEX LISTED OPTIONS (PUTS AND
CALLS), (MAY, 1977) [hereinafter cited as AMEX REGULATORY GUIDE-
LINES ] .

29/ Id. at 4.

352

Evidence suqqests that firms do not follow these exchange guidelines.
In some cases, the oroblem might be solved by a simple exercise in drafts-
manship, in that some firms' account forms for options customers do not
have places for the transcribing of information specified by the self-
regulatory organizations. For example, some forms do not have a space
in which a customer's net worth or occupation can be disclosed, and many
do not provide room to record liquid net worth, dependents, or previous
investment exoerience.

In other cases, however, firms seem to shield themselves from information
about customers which miqht bear on suitability. Registered representatives
are not encouraged or required to be candid about a prospective customer's
circumstances even though registered representatives are often in possession
of uniaue suitability information. The Options Study reviewed several
situations where this lack of candor prevented critical facts concerning
a customer's circumstances from being revealed to the supervisors who
had to make the appropriate suitability determinations. For instance,
the Options Study found the following examples of customers whose information
forms suggested financial resources for options trading, but who had
other, unrecorded problems which were generally known to their registered
representatives and which raised questions about the suitability of
options for them:

. A retired couple with assets of more than $100,000 and income
of $12,000, but where the husband was fully disabled, was
receivinq outpatient mental care, and where the couple had
an adult retarded child fully dependent on them;

353

A woman who appeared to have adequate resources to engage
in options trading but who appeared to be mentally unstable,
extremely nervous and confused, and had no understanding
of financial matters nor family or friends to help her;

A twenty-year old who appeared to have substantial assets, but
who was completely unsophisticated in securities matters and
whose net worth consisted of an inheritance resulting from
the death of both parents and upon which he depended for
income ;

Several customers with varying financial resources and
prior securities investment experience, but who spoke no
English;

. Several investors who appeared to have substantial

assets to invest, but who were widows with small children
and whose assets were a family house and their husbands'
life insurance proceeds.

In other cases, registered representatives did not completely
fill out the suitability forms. A recent examination at one major
retail brokeraqe firm revealed that 69 percent, or 62 out of the 90
sampled options customer information forms, were lacking information
as to net worth, annual income or investment objectives. Similarly,
an NASD survev indicated that some of its members have failed to maintain
sufficient suitability information.

Firms sometimes argue that incomplete records of suitability infor-
mation do not necessarily indicate that the firm does not have complete
information. Rather, they urge, the account may have been approved on
the basis of information not disclosed on the form. But failure of
a firm to record all of the pertinent information upon which a suitability
determination is based makes virtually impossible the supervisor's task

354

of adeouately reviewinq an office's compliance with account opening
and suitability standards. In addition, without properly recorded
suitability information, the self-regulatory organizations cannot
detect suitability or account opening abuses occurring within member
firms.

Several brokerage firms allocate space on their account opening
or account information forms for the registered representative to note
certain matters of relevance to the firm's promotional efforts, such as
how the account was acquired and whether to send various solicitation
materials to the customer. Accordingly, it should not be burdensome
to reauire that brokeraqe firms use customer information forms to
obtain the suitability information already recommended by exchange
quidelines and to provide space on the forms where the registered
representative must record any special matters which bear on a particular
customer's suitability.

In order to assure more diligent inquiry into a customer's background
for suitability purposes, the Options Study recommends:

TOE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND
THEIR OPTIONS RULES ( 1 ) TO PROVIDE A STANDARD OPTIONS
INFORMATION FORM WHICH REQUIRES THAT BROKER-DEALERS
OBTAIN AND RECORD SUFFICIENT DATA, AS SPECIFIED BY THE
RULES, TO SUPPORT A SUITABILITY DETERMINATION; (2) TO
REQUIRE FIRMS TO ADOPT PROCEDURES TO INSURE THAT
ALL THE INFORMATION ON WHICH ACCOUNT APPROVAL
IS BASED IS PROPERLY RECORDED AND REFLECTED IN
THE FIRM'S RECORDS.

355

c. Timely review of suitability information

Exchange rules require that an account be approved for options

trading before a firm accepts any options order from a customer. The

account must be approved in writinq by an ROP who is an officer or

oartner of the firm, but in the case of a branch office:

an account may be approved for options transactions
by the mahaqer of such branch offices, in which event
the action of the branch office manaqer shall within a
reasonable time be confirmed by the Registered Options
Principal. 30/

To comely with this reouirement, many firms have their registered

representatives fill in the customer information form which, along with

the other account opening documents, is reviewed by the branch manager

who approves the account for trading. But the manager is not always

an ROP, and he does not always have sufficient options expertise to

nrooerly evaluate the customer information for suitability purposes.

Although the home office ROP may eventually reject the account or limit

the account's trading to certain options strategies, the account is,

meanwhile, permitted to trade options and may be engaging in unsuitable

transactions. In some instances, several months may pass before an

ROP reviews the account.

The Ootions Study believes that the recommendation in Subchapter "8"

of this chapter, "Supervision of Accounts", that all branch managers

30/ Rule 9.7(b), CBOE GUIDE (CCH) 1| 2307.

356

be ROP Qualified, may alleviate the problem of untimely review by a
oualified employee for approval of new customers for options trading.

4. Problems of Continuing Supervision

h firm's responsibilities regarding suitability do not end after it
has made the initial suitability determination and has permitted a customer
to ODen an options account and commence options trading. Exchange rules
reouire the firm to make continuing suitability determinations with regard
to each recommended options transaction. In addition, the rules of all
options exchanges, other than the CBOE, also require a similar determination
with regard to all put writing or uncovered call writing transactions,
whether or not recommended, lb fulfill these responsibilities, firms
need: (1) to assure that suitability information is appropriately updated;
(2) to establish adeauate account review procedures; and (3) to maintain
customer suitability records in locations which assure their availability
for use .

a. Current suitability information

Information obtained from a customer at the time an account is opened
freouently becomes outdated for a variety of reasons. As a customer
continues to trade listed options, his increased knowledge and understanding
of the risks involved in options trading may help alter his investment
objectives and, therefore, the suitability of various types of options
trading for him. In addition, a registered representative's relationship

357

with his customer may develop over a period of time, enabling the regis-
tered representative to learn additional information about his customer's
financial situation and investment objectives. And, of course, the
financial resources of customers may change with time.

Rarely, however, are customer account opening forms updated to
reflect changes in the customer's financial information, investment
objectives, or financial sophistication. In almost all firms surveyed
by the Options Study, account opening documents are reviewed to assure
that they contain current information only when a serious question
arises concerninq the account.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND THEIR
RULES TO REQUIRE THAT MEMBER FIRMS SEMI-ANNUALLY
CONFIRM THE CURRENCY OF CUSTOMER SUITABILITY
INFORMATION.

b. Account review procedures
As discussed in subchapter "B" , "Supervision of Accounts", most
firms traditionally have placed primary responsibility for supervision
of customer accounts on their branch office managers where the incentive
to supervise may be absent, and the manager's understanding of options may
he in doubt. Even where the manager is competent and properly motivated,
however, the task of performing adequate account reviews without assistance
is difficult, particularly in offices which do a high volume of options
business. Some firms have recognized the need to provide help to branch

358

manaqers and have developed computer-assisted programs to support
branch managers in performing account reviews. In some firms, the
computer runs are reviewed by home office compliance personnel and
in others they are given to the branch office manager to assist him
in his review of customer accounts. Some of these programs have a
particular relevance to options and include:

(1) daily exception runs to identify customer options
transactions in customer accounts not approved for
options trading;

(2) daily exception runs to highlight customer options
transactions which fall outside the types of options
investment strategies for which the customer is
approved ;

(3) monthly or quarterly runs to identify all customer
accounts which generated more than a specified amount
in commissions, or which undertook more than a speci-
fied number of options transactions, or both.

A few firms have begun to use computer programs which correlate
a customer's transaction activity with financial and other data con-
cerninq the suitability of options trading for him, eliminating the
need for cumbersome manual cross referencing of trading with background
information. Several firms employ computer runs which show increases
or decreases in customer equity on a periodic basis and by year-to-date

359

On the whole, however, the Ootions Study found account review pro-
cedures employed by brokeraqe firms to be inadequate to assure a
firm's adherence to suitability reauirements. First, not all firms have
developed automated methods of reviewing customer accounts. Some
firms, even a few with multi-million dollar revenues from their options
business and thousands of customers approved for options trading,
appear to rely heavily on clearly antiquated manual spot-checks, and
other "random" samplings to review customer options activity. For
example, one firm with more than $1.3 million in options revenues
in 1977, and more than 1,200 customers approved for options trading,
informed the Options Study that it conducts only monthly branch office
and ouarterlv home office random manual reviews of customer accounts.
Another firm, with more than $800,000 in options commission revenues
in 1977, and 2,500 customers approved for options trading, appears
to have almost completely abdicated its account review responsibilities,
conduct inn only an annual review of a random manual selection of customer
accounts.

Second, while some firms have developed account review programs
specifically related to options, many still use only account review
procedures developed to detect problems involving stock trading in
customer accounts. Certain of these stock account review procedures
are useful in detecting problems relevant to customer options trading
(e.g. , excessive trading and commission reviews), but, in general,
these programs cannot detect options trading activity which entails

360

larqe or rapid increases in risk to a customer account. Adaptations
of customer credit monitoring systems by some firms have not always
been a dependable means of monitoring customer risk.

lb illustrate this problem, the Options Study identified several
types of options transactions in customer accounts which normally
indicate precipitous increases in customer risk and may signal unsuit-
able tradina strategies, and asked the firms in the industry group
sample whether they had procedures designed to detect such trading.
The activities include: "Leg-Lifting" in spread positions,* converting
covered call positions to uncovered call positions, large scale writing
of uncovered call options, and exercises of long call positions prior
to expiration week. The chart below shows the responses of the firms.

FIPM HAS PROCEDURES

TO DETECT: YES NO

"Lea-Lifting" in spread 46% 54%

oositions

Convert inn covered call 50% 50%

oos it ions to uncovered
call positions

Larqe scale writing of 79% 21%

uncovered call options

Exercises of long call 46% 54%

positions prior to ex-
piration week

* An options "spread" position consists of a "long" side, i.e. , the holder
of the position has purchased an option, and a "short" side, i.e.,
the holder of the position has also sold an option. Each side of the
position is called a "leg". If one side of the position is closed,
as for example, if the holder sells the options in the long "leg",
the leg is said to be "lifted", hence the expression, "leg-lifting."
Once one leg is lifted, the investor is exposed to risks inherent
in other leg.

361

These data suggest that many firms are unable to detect trading
oractices which are of themselves warning signs of unsuitable trans-
actions. The Ootions Study believes that implementation of its recom-
mendations concerning account review Drocedures made in subchapter H,
entitled "Options Trading in Customer Accounts" will help to ensure
that broker aae. firms have such a capability,
c. Keeping suitability records

Rule 17a-4 under the Exchange Act requires that firms maintain all
customer account information during the life of an account (and for
six years after the account is closed). Cne obvious purpose for the
reauirement is to enable firms to assist customers in pursuing investment
programs suitable to their needs. This purpose can be thwarted, however,
if the information is not kept at locations where it actually can be
used. At present, Rule 17a-4 and the equivalent rules of self -regulatory
organizations do not specify that the records be kept at any particular
Dlace. As a conseauence, many firms have not adopted record maintenance
policies which assure that the account information will be kept in
the Dlaces where it is needed .

lerhaps because most self-regulatory organizations inspect the
home office of a firm far more frequently than branch offices, many
firms retain records of customer account statements, background and
financial information only at the home office. Yet, since most invest-
ment recommendations for customers are made at the branch offices, the

362

Options Study believes that the information is also needed there. In
addition, unless branch managers have access to and use such information
in reviewing customer transactions for suitability, such reviews are
of Questionable value.

The Options Study has been told by some in the industry that no
useful Duroose would be served by requiring that background and account
information be retained at the sales office level. If the branch is
small, the argument goes, a manager's personal knowledge of his customers
orovides an adequate basis for assessing suitability; and if the branch
is lane, customer transactions are too voluminous to permit the
manaqer to cross-reference a customer's trading with account,
background and financial information.

These arguments are not persuasive. Regardless of the utility of
the information for supervisory reviews, the information should be
available to registered representatives who make recommendations
and qive advice to customers before orders are entered. In addition,
while there may be instances in which the branch manager's personal
knowledae of his branch's customers obviates the need for recorded in-
formation, the Options Study has reviewed too many cases of unsuitable
tradinq to conclude that a manager's "personal" knowledge serves as an
adeauate basis for conducting suitability reviews. Indeed, these cases
suggest that if the registered representatives knew that the sales-
manager had ready access to suitability information, they might have
refrained from effecting obviously unsuitable trades in customer accounts.

363

As for the arqument that such information, however relevant, is simply
iqnored in larqer offices because of time pressures, the solution for
the firm is not to disregard valuable information, but to develop adequate
and perhaps automated procedures to supervise properly the options business
transacted bv customers of the firm.

Moreover, the need for account, background and financial infor-
mation to be available at broker-dealer sales offices transcends the
value of such information to the firm itself. During a recent special
sales office inspection program conducted by the Commission's staff,
durinq which more than 150 sales offices were inspected, the Commission's
staff repeatedly encountered difficulties in conductinq proper reviews
because customer account and background information was unavailable.
Obviously, the task of Commission and self-regulatory organization
inspectors in adeauately reviewing the suitability of trading in
customer accounts at a branch office would be made far easier — and
would be accomplished more quickly — if customer account information
were available for review at the branch. Accordingly, the Cptions
Studv recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RECORDKEEPING RULES WHICH REQUIRE THAT MEMBER FIRMS
KEEP COPIES OF ACCOUNT STATEMENTS, AND BACKGROUND
AND FINANCIAL INFORMATION FOR CURRENT CUSTOMERS, AND
MAINTAIN THESE RECORDS BOTH IN A READILY ACCESSIBLE
PLACE AT THE SALES OFFICE AT WHICH THE CUSTOMER'S
ACCOUNT IS SERVICED AND IN A READILY ACCESSIBLE
HEADQUARTERS OFFICE LOCATION.

364

5. Suitability - A Final Note

The Oct ions Study believes that the changes recommended in this

section, if adopted, will improve significantly brokerage firms'

controls over the suitability of listed options trading for customers.

Certain of the suitability abuses encountered by the Options Study,

however, indicate far more than inadequacies in the current control

systems of brokerage firms. For instance, the Options Study found the

following suitability cases:

As the result of an automobile accident resulting
in a head injury, one individual developed serious
emotional problems and memory difficulties which
prevented him from holding a job. He had been
fired from more than 20 jobs and his total annual
income consisted of income from the accident com-
pensation award and approximately $5,000 in social
security disability payments. This customer's
reqistered representative invested the customer's
entire assets in an aggressive options trading
program which resulted in losses of more than
$70,000 over a two year period. The registered
representative showed complete disregard for his
customer's limited income, mental incapacity and
dependency upon him and stated in one internal
memorandum that the customer: "has enough assets
to guarantee payment of whatever his little mind
can logically dream up".

Another customer was completely unsophisticated about
financial matters and had no prior experience in the
market other than an investment in a mutual fund. She
had an eighth grade education and her husband a fourth
grade education. At the advice of her registered
reoresentative , she invested her entire $36,000 portfolio
in a margin account trading options. She suffered
substantial losses.

365

A retired coirole with a fixed income of approximately
$12,000 a year had a portfolio of New York Stock
Exchanqe listed stocks which they acauired over a
Deriod of about 25 years, some of which they had
given to their only daughter who was almost completely
disabled. The daughter had an annual income of less
than $5,000 and a net worth of about $45,000. A regis-
tered representative persuaded both the daughter
and her oarents to sell a substantial part of their
stock and to enter into a program of writing calls
covered by warrants, a risky strategy which resulted
in 'significant losses in both accounts.

Cases such as these, and cases of repeated violations, can
occur only where brokerage firms and their employees ignore the obligations
imoosed on them bv the suitability doctrine and act irresponsibly. In
the last example above, when questioned by a self-regulatory organization
about its failure to orevent its registered representative from making
such obviously unsuitable options trades, the brokerage firm responded
that its supervisors had no obligation to know of the specific physical
condition of the customer and that reporting or recording the customer's
known rhvsical disability would be an infringement of the customer's rights.

Another major brokerage firm was sanctioned by the Commission
in 1978 for willful violations of the antifraud provisions of the
Federal securities laws in a case in which customers were permitted
to enqaae in unsuitable options trading and the firm's suitability
screening procedures were found to be ineffective. An inspection of
the firm's options trading activities within six months after the
Commission's enforcement proceeding indicated that as many as

40-940 O - 79 - 26

366

twenty-five percent of the firm's options customers still were trading
options at strategy levels more advanced than those approved by the
firm.

The Oct ions Study believes that the self-regulatory organizations
and the Conmission should take all steps necessary to focus the
attention of brokerage firms on their responsibilities toward their
ootions customers under the suitability doctrine. The rule changes
recommended here should ease this enforcement effort by improving
recordkeeping procedures and by providing critical data in a form usable
to both firms and regulators. Without such an effort, however, violations
will continue, the rule changes recommended will be meaningless, and
salesoersons, like the one in the following recorded conversation,
will continue to put customers, including those who financially do not
belonq in options trading at all, into such clearly unsuitable options
positions as the one transacted below.

EXCERPT FROM A REGISTERED REPRESENTATIVE - CUSTOMER CONVERSATION

SALESMAN: All riqht. Now ... we put a naked [call option position]*
into your account today.
Tried to call you, but I guess you were at school.

* Selling "naked" or uncovered call options is one of the most risky
undertakings in which an options customer can engage. It involves
selling an option entitling the buyer to demand delivery of stock
the seller does not own.

367

CUSTOMER: No, I didn't have any classes. I was trying to get
a credit card.

SALESMAN: ....What kind of credit card were you trying to get?

CUSTOMER: Well it was at [a bank] , trying to talk him into giving
me credit for a ... Master Charge or a Visa. Now they
sent me back a rejection notice, and I'd gotten one
from Bank America said one thing, and [the bank] said
I didn't have enough steady income, so ... I took in
the statement from [your brokerage firm].... He said
he was going to look it over this afternoon and call
me back. It's not a steady income I guess, until you
have two or three years of it.

SALESMAN: It really is a bummer. How much longer of school do you
have left? Or don't you know?

CUSTOMER:

SALESMAN;

CUSTOMER:

I could graduate with a degree in anthropology in June,
if I wanted to, but I'm more or less a professional
student, because I don't see any job at the end of the
line.

Not in anthropology. Okay. One thing you might want
to do, you might want to put my name down, for instance,
as a credit reference if you fill out another form.
Well, it's kind of a standard thing. I did put of course
[your brokerage firm] down ....

368

SALESMAN: Because, see, bankers are funny people, and usually the
quy that's looking at this is some clerk who makes, you
know, four hundred dollars a month, and they gave him
a form in front of him, and it said, unless this answer
is answered this way, and this answer is answered that
way, you reject the guy. You know how it works. So ...
maybe we can talk to the clerk and let him know what's
happening.

* * *

SALESMAN: Okav. Anyway, getting back to the naked [call option
oosition] we put in your account today...

The customer above eventually lost $6,000, a substantial amount
of which was in commissions paid to the brokerage firm and this
©articular salesman.

369

D. DISCLOSURE DOCUMENTS

In many cases, the options customer is the person best motivated
to orotect his own financial interests and to oversee his own options
tradinq. However, unless the customer has sufficient information, in
an understandable form, with which to assess both the risks of options
trad inn and the. status of his account, he cannot adeouately guard his
own interests. The rules of the Commission and the self -regulatory
oraanizations reouire that an options customer be furnished with several
documents intended to inform him, at the time he opens an options account,
of the risks of options trading and, once he has begun trading, of the
status of his account. These documents include a current OCC prospectus,
customer account statements, and written confirmations of each options
transaction in the customer's account. The Options Study has found
that manv customers are unable to understand the prospectus and their
account statements. Not only are these documents frequently too complicated
or too crvotic, thev also aooear to be ineffective as safeguards both
for the customer who is drawn to options by a misleading sales presentation
and aoainst the registered representative who is engaged in improper
activitv.

1 . Account State":

In order to Droperlv oversee his options account, a customer must
first be able to understand his account statement. The Options Study
has found, however, that many customers, and even some supervisors,

370

cannot understand these monthly statements well enough to calculate
easily the status of the account. Sometimes this difficulty results
from the complexity of options trading. At other times, however, lack
of understanding is the result of insufficient disclosure on customer
account statements.

As a result of the inability of many customers to understand their
account statements, registered representatives have been able to mislead
customers about the Drofitability of their options transactions
sometimes for months at a time. These deceptive activities would have
been detected easily by the supervisors of the firm had the customer's
ootions account statement disclosed essential information more fully
and clearlv. In one case, the Options Study found that a registered
representative had directed his firm to send to several of his options
customers monthly withdrawal checks, siphoned from their own existing
eouity reserves but designed to appear to the customer as "profits"
from his options trading program. All the while, each customer's account
eouity was dwindling even further as a result of losses incurred in
the salesman's trading programs, losses which were not disclosed by the
account statements. A monthly account statement which disclosed current
eouity in a customer's account would have prevented, or at least dis-
couraoed, this deceptive practice.

Recent improvements in the account statement form produced by some
firms have proved to be of helo to those firms' customers. For example,

371

one customer, who had been convinced by a registered representative

at a national brokerage firm to engage in exotic options strategies

for five months, described his experience with unintelligible brokerage

firm statements prior to August of 1977:

Before I knew it, I was receiving a large
number of confirmation slips for both opening
and closing spread transactions. I was
thoroughly confused by all the confirmations.
... I was unable to follow the trading nor was
I able to understand the monthly account
statements.

In August of 1977, however, this investor's brokerage firm began

disclosing account equity on customer monthly statements. The same

investor testified about the effect of these disclosures for him:

At the end of July, I agreed to put on some
straddles in order to eliminate my margin
balance. When I received my August 31, 1977
account statement, I discovered that my port-
folio value had decreased from $93,000 to
$67,000. At this time I decided to talk with
[my registered representative] about the con-
dition of my account with the manager of the
office present.

The Options Study encountered other cases where customers similarly
learned of substantial losses in their options accounts only after
their accounts were transferred to brokerage firms which disclosed the
current value of the options account.

Very few firms in the industry group sample provide account
equity information on customer account statements and even fewer
include commission information on such statements. Several firms

372

do have commission information on internal copies of account state-
ment forms, but only one firm sends this information to customers.
No firm in the sample group provides on the account statement the
name of a supervisor whom the customer might call with questions
about his account. The table below sets out the practices of the
industry group sample with regard to other customer account state-
ment disclosures:

ACCOUNT STATEMENT
SHOWS

YES

Commissions attributable
to each transaction during
period

98%

Current price of each security
at end of period

12%

83%

Current value of portfolio
at end of period

91%

Change in portfolio value
during period

100%

All firms in the industry group sample disclose the amount of margin
loans outstanding and interest expenses incurred during the period covered
by the statement, as required by Exchange Act Rule 10b-16.

Exhibit A is an expanded version of a customer's monthly statement,
prepared by a major brokerage firm for one its active options accounts
for the month of May 1978. Registered representatives of the firm
routinely receive this copy of their customers' monthly statements

373

which include all of the followinq items: interest expenses (year-to-
date); aqnreqate commissions (year-to-date); account equity (marked
to market); eouity variation since last statement date; commissions
attributable to each transaction; and the current market value of
each position in the account. The customer, however, is sent a copy
of the statement which includes none of this particular information.
As can be seen from Exhibit A, the registered representative receives
the whole account sheet, while the customer is sent only that
information to the left of the arrow.

For an options customer to be able to oversee his own account he
must receive an account statement which allows him to determine, by
simole inspection, both the current value of his account and any chanqe
in his account value during the period covered by the statement. It
should disclose all costs incurred durinq the period includinq commissions
attributable to each transaction, and, of course, it should show the amount
of any marain loans outstandinq.

Accordinqlv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES REQUIRING THE OPTIONS CUSTOMER'S ACCOUNT
STATEMENT TO SHOW THE EOUITY IN THE CUSTOMER'S
ACCOUNT WITH ALL OPTIONS AND OTHER SECURITIES
POSITIONS MARKED TO MARKET AND THE YEAR TO DATE
PROFIT OR LOSS IN THE ACCOUNT CLEARLY SHOWN.
THE OPTIONS CUSTOMER'S ACCOUNT STATEMENT SHOULD
ALSO SHOW THE AMOUNT OF MARGIN LOANS OUTSTANDING
AS WELL AS COMMISSION CHARGES APPLICABLE TO EACH
TRANSACTION AND OTHER EXPENSES PAID OR PAYABLE,
FOR THE PERIOD COVERED BY THE ACCOUNT STATEMENT
AND YEAR TO DATE.

374

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377

The OCC Prospectus

The Oct ions Clearing Corporation ("OCC") prepares and files a regis-
tration statement under the Securities Act of 1933 (the Securities Act)
as the "issuer" of all listed options traded on the five options exchanges.
This registration statement includes the options prospectus and is filed on
Form S-l , the Commission's general registration fotm, which is used when
no other specialized form has been designated by the Commission's rules.
The most recent options prospectus contains 56 printed pages providing
in considerable detail information about OCC itself and information about
listed options, their risks and the mechanics of options trading. Exchange
rules reouire that this prospectus be delivered to every customer at or
prior to the time his account is approved for listed options trading.
The costs of preparation and distribution of this document have been es-
timated to exceed $1,250,000 annually.

Includinq information about the OCC as an issuer for purposes of the
Securities Act as well as information about options trading and mechanics
has resulted in a lengthy and complicated prospectus which does not meet
the needs of option buyers or sellers who may lack the financial background
to understand the current prospectus.

Unlike other registration statements which are designed to give a
prospective purchaser of a security sufficient information about the
issuer of the securities so that an informed investment decision can
be reached, the options prospectus is designed to provide options buyers
and sellers with adeouate information about options trading and about
the listed options market. Information about the issuer, such as the

378

nature of the issuer's business, its officers and directors, competitors,

and its financial statements, are of little concern to the audience

at whom the OCC prospectus is directed since no purchaser or seller

of listed options is really making an investment in OCC. Counsel for

the OCC has commented that:

The most useful disclosure for investors
does not involve a description of the issuer
and its business, but instead calls for a
description of the economic risks and uses
of options and the mechanics of buying,
writing and exercising options. ... Such
disclosure bears no relationship to OCC's
role as issuer or clearing corporation, but
instead relates to either the basic economic
characteristics of options or to the rules
and Drocedures of the various exchanges
that provide a market for options. /

The American Bar Association has urged that options should be exempted

from the registration provisions of the Securities Act and has offered the

following three reasons in support of their position:

The 1933 Act registration is an inefficient
and unnecessarily costly way of educating
the public regard inq options trading and
disclosing the attendant risks and obliga-
tions. Second, the imposition of the 1933
Act liabilities on parties involved in
issuinq and trading standardized options
is inappropriate and may adversely affect
the quality of public disclosure regarding
options. Third, exempting options from the
registration provisions of the 1933 Act would
clarify the uncertain legal status of the over-
the-counter options market and permit equal
regulation for standardized listed options
and over-the-counter options. /

/ Letter dated November 28, 1978 from Schiff Hardin & Waite, Counsel
to the OCC, to Richard L. Tfeberg, at 2.

/ Letter dated October 24, 1978 from the Subcommittee on Regulation
of Securities Oct ions of the Committee on Regulation of Securities,
Section of Corporation, Banking and Business Law of the American
Bar Association to Richard L. Teberg, at 3-4.

379

Concern by the OCC with Securities Act statutory liabilities,

which normally are imposed upon issuers involved in public offerings

of their own securities, has affected the manner in which OCC has

drafted the options prospectus. Counsel for OCC has noted that:

because of the strict liabilities under the
1933 Act, the OCC prospectus has had to be
drafted in the "defensive" style that is
characteristic of the 1933 Act documents,
tendinq to err on the side of too much dis-
closure, and to include highly technical
descriptions and disclaimers covering
various remote contingencies. /

Procedural requirements under the Securities Act have also resulted

in substantial costs in connection with the OCC prospectus. For

example, Section 10(a)(3) of the Securities Act prohibits the use

of a prospectus more than nine months after the effective date of

the registration statement if the prospectus contains information

which is more than sixteen months old. The American Bar Association

has commented that:

[the requirements of Section 10(a)(3)] when
couoled with the requirements of Form S-l
that call for current financial statements
to be included in a prospectus, has the
effect of reauirinq a new OCC prospectus
to be prepared, filed with the Commission,
and distributed to the public on or before
October 31 of each year , regardless of
whether there have been material changes in
the relevant information contained therein.
Because of the size of the OCC prospectus
(currently 56 pages) and the number of copies

/ Letter dated November 28, 1978 from the OCC, at 2.

380

to be distributed (well over 1,500,000 annually),
the cost- of preparing and distributing a new
prospectus is enormous. In addition, because
of the threat of civil liability under Section
12(1) of the 1933 Act for failure to deliver
a current prospectus (whether or not the changes
from a prospectus previously delivered are
material), brokers and dealers have been required
to establish costly controls to ensure that all
customers receive each new prospectus as it
becomes available. /

The Ootions Study has concluded that information concerning listed
options should be disclosed to investors in a manner readily understandable
to a reader with no financial training and that information about options
and the trad inn markets for options can and should be separated from infor-
mation about the OCC. Absent a statutory amendment, the offer and sale of
anv security, includinq listed options, must continue to conform to the
reauirements of the Securities Act. /

In order to satisfy the requirements of the Securities Act, and in
recoqnition of the unique kind of "offering" represented by the issuance of
listed ootions, the Options Study has the following recommendations.

/ Letter dated October 24, 1978 from the ABA, at 5.

/ The Commission had earlier attempted to reconcile the problem of selling

options with the registration requirements of the Securities Act by pro-
posinq new Rule 238 under the Securities Act to exempt the offer and sale
of certain over-the-counter options from Securities Act registration. A
new Rule 9b-2 under the Exchange Act was also proposed at the same time
which would have imposed disclosure, suitability, and net capital require-
ments on brokers and dealers executing customer transactions in options.
See Securities Act Release No. 5366 (February 8, 1973) and Securities
Exchange Act Release No. 9994 (February 8, 1973). Neither of these
proposed rules was adopted.

381

Compliance by the OCC with the Securities Act can be satisfied
bv the filinq of a special form of registration statement and
orospectus designed for OCC as the issuer of options and adopted
pursuant to the Commission's authority under the Securities Act.
This special form would include information relating to the OCC,
including a description of its business and financial reports.
Under Securities Act Pule 153, the OCC orospectus would be available
to the public upon reouest but could be deemed "delivered" to
each options customer by the OCC when copies of the OCC prospectus
were furnished to the exchanges on which listed options are traded.

Tb rxovide investors with an appropriate disclosure document, a
new document prepared by OCC would be required under the Exchange
Act to be delivered at or prior to the time of an options customer
ooens an account. This document, designed for persons without
financial training, would provide investors with a simple descrip-
tion of the risks and uses of put and call options. This new
document should include a glossary of terms; a description of
(i) the risks of options trading, (ii) the fundamental uses of
options trading, (iii) the terms of options, and (iv) the mechanics
of buying, writing and exercising options; and a simplified discussion
of transaction costs, margin reauirements and tax consequences
of option trading.

This Exchange Act disclosure document could be adopted pursuant
to the Commission's broad authority to regulate options trading under Section

40-940 O - 79 - 27

382

9(b) of the Exchanqe Act. For the reasons cited by the OCC, / the Options
Study believes that this Exchange Act disclosure document should not be
filed as Dart of nor incorporated by reference into a Securities Act
reqistration statement filed by the OCC as the technical "issuer" of all
listed options.

In view of the potential liability for omissions in a Securities
Act Drosoectus, and in recognition of the fact that the Exchange Act
disclosure statement will contain substantial information now included
in the OCC prospectus, it would be desirable for the Commission to find,
pursuant to its authority under Section 7 of the Securities Act, that
certain disclosures concerning options trading which now are included
in the OCC Drospectus are inappropriate under the new Securities Act
reqistration form developed for the OCC.

Alter nativelv, as part of the promulgation of a new Exchange Act
disclosure document and a more limited Securities Act registration state-
ment, the Commission might set forth certain "safe harbor" provisions
which have the effect of relieving OCC and its officers and directors
from liability for omission of certain material from the Securities
Act reqistration statement which would be included in the Exchange
Act disclosure document. This might be patterned after the recently
proposed safe harbor provisions in connection with projections in
statements filed under the federal securities laws.

/ Supra at 3.

383

The effect of these recommendations would be to relieve OCC from
liability under Section 11 of the Securities Act for disclosures
relating to a description and uses of options and the mechanics of
the options trading markets, matters with respect to which OCC has

no special expertise or control. / Regardless of the statutes

under which forms are required or filed , the overriding concern of
the Options Study is that potential options traders be furnished with
a disclosure document designed specifically for their needs and, in
particular, for the needs of those investors with little or no financial
training.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD ADOPT A SPECIAL REGISTRATION
FORM UNDER THE SECURITIES ACT FOR OCC WHICH WOULD
NOT REQUIRE OCC TO DESCRIBE INFORMATION ABOUT OPTIONS
TRADING AND SHOULD EXERCISE ITS AUTHORITY UNDER THE
EXCHANGE ACT TO REQUIRE THAT A DISCLOSURE DOCUMENT
FILED UNDER THE EXCHANGE ACT DESCRIBING OPTIONS, THEIR
RISKS AND THE MECHANICS OF OPTIONS TRADING BE PREPARED
BY OCC AND BE DELIVERED BY BROKER-DEALERS TO EACH OPTIONS
CUSTOMER AT OR PRIOR TO THE TIME THE CUSTOMER OPENS AN
OPTIONS ACCOUNT.

/ Neither alternative, however, would effect the present status of
conventional options under the Securities Act, namely, that their
offer and sale must oe effected in compliance with Section 5.

384

E. PROMOTING OPTIONS - GENERAL PROBLEMS

1. Introduction

In order to establish and maintain an options business, that is, to
sell and promote options, a brokerage firm needs to communicate with
actual or Dotential customers. Communication is necessary first to
attract the customers to the firm — a practice known in the industry
as "prospectinq" — and then to keep customers interested in options
and in doing business with the firm.

Firms must also communicate with customers for reasons other than to
nromote business. Before options trading may be considered suitable for
a customer, the customer should understand the risks involved in such
tradinq. Since the customer must rely, in large part, on the brokerage
firm and its representatives to explain those risks, communications from a
brokerage firm may have an educational as well as a promotional purpose. In
fact, information supplied to customers by firms generally serves these dual
and often competing needs. Finally, a firm must communicate with actual
customers to keep them informed of the status of their accounts and of
transactions done in their accounts.

At each stage in the communication process, brokerage firms and their
reqistered representatives use a variety of materials and methods to reach
customers. Some firms use mass media advertising extensively. Some firms
give freouent "seminars". Most firms allow their registered representatives
to solicit new business or generate more business through telephone calls.

385

Promotional materials may also be mailed to "prospects" and existing custo-
mers, or may be available at seminars or in brokerage firm offices as
"handouts."

The Ctotions Study has reviewed the various types of solicitation and
informational materials used by firms to acquire and inform options
customers. These materials include advertisements and sales literature,
seminar scripts, promotional letters, worksheets and performance reports.
The Ootions Study has also studied a particular sales technique which
seems to be unusually effective in enlisting options customers — the
"options proqram."

Althouqh each of these types of materials and solicitation techniques
have special problems which will be discussed in following sections, one
recurring shortcoming of virtually all types of sales promotional efforts
is the underlying message used to attract options customers. The promotional
messaae, conveyed explicitly to the customer by both the brokerage
firms and the individual registered representatives, is that predict-
able and verv attractive returns on investment are available, with
a minimum of risk, to persons who use options in their investment
orograms. Vhile this message serves as the most effective means
of persuading customers to consider options as an investment, it
is frequently misleading.

386

2. Rates of Return on Investment

A rate of return expresses the relationship between the amount
a customer invests and the amount he earns from that investment. For
example, if $100 is earned from a $lf000 investment in a period of one
year , the rate of return is 10 percent per year . Rates of return can
be used either to measure the past profitability of an investment, as
in a performance report, or to project the profit potential of an
investment, as in a worksheet.

When properly used, rates of return may be informative to an
investor, but the Options Study believes that options investors
qenerally are misled by the use of rates of return. First, firms
and reqistered representatives tend to overemphasize attractive
ootential rates of return from options investments while de-emphasizing
the risks of options investments. Second, rates of return are often
expressed on an annualized basis without any clear discussion or
disclosure of the many assumptions which must be made to express the
return on an options investment in annualized terms. lb compound the
Droblem of the use of rates of return, firms and salespersons sometimes
qive customers the impression that an attractive percentage return on
a recommended options investment or series of investments can be predicted
with certainty, thus leading customers to believe that a profit is promised
or guaranteed.

387

a. Exaggerated rates of return

The Options Study has found that attractive rates of return are

used in virtually all types of promotional efforts designed to increase

investor interest in options, and are used also in materials designed to

"educate" customers about options. Typical are the following conclusions

in a national broker aqe firm's option writing guide:

Hdw much income? Hdw much downside protection?
No assurances can be given. But we believe — based
on what has haopened over the years — that an option
writing program can be expected to produce a yield
of about 15% a year on vour capital. That's in stable
or rising markets. In falling markets, an option
writer can possibly acouire protection against a
decline of about 15% a year in equity capital.

That isn't yield of course, as in the case of stable
or rising markets, but protection. In either case, this
oercentage figure represents hard cash premiums received
at the time of writing an option. Cash that can add to
caoital or replace capital eroded by declines in stock
prices.

On the basis of these statements, several registered representa-
tives have assumed that rates of 15 percent and higher are reasonable
returns for options programs and have led customers to expect these
kinds of return. Some financial writers have used this national
brokerage firm's claim to support their assertions that even greater
rates of return are possible from listed options trading. A regional
options coordinator in one firm used this statement as the basis
for suggesting to registered representatives that they use sales
presentations which spoke of an "expected 15% to 20% return."

388

The options exchanges also have contributed to the overstating
of rates of return. For instance, the CBOE has distributed as part
of its promotional materials a reprint of an interview in which
one of its governors told readers of a widely circulated financial
publication:

[A]s a conservative investor, I can write

[sell] ootions to increase my total return
from that portfolio of stocks in companies I
believe in. People talk about option spreading
programs and mention 15%, 20% a year if they're
lucky. That's peanuts to what a conservative
investor can earn by holding stocks and writing
options on them.

Some salespersons have used this interview routinely in order to solicit

new options customers.

The results of options trading, however, often are very different from

the returns the customer has been led to expect. For example:

. Che investment advisor - registered representative team

premised an investor who spoke little English a 1000 percent
return on her $2,000 investment in options over a period of
several months. The investor lost her entire investment.

Another registered representative told several customers
about the 70 percent return he could consistently achieve for
clients throuqh an uncovered call writing program. All of
these investors suffered substantial losses as the result of
this options trading program.

Two investors claimed that their registered representatives
predicted that they would "double" their money in a short
period of time. Both lost substantial parts of their investment,

389

. One registered representative promised same prospective
clients between 10 and 500 percent return on options
investments and other prospective customers "fantastic"
returns with "minimal risk". After fifteen months
of trading, his thirteen most active customer accounts
had all experienced losses, ranging from 13 to 74
oercent of the money invested .

b. Annualized rates of return

When a return on an amount invested for either less or more than
a year is expressed in terms of a yearly rate, it is said to be "annualized.1
For example, an investment which results in a 5 percent return in four
months is said to yield 15 percent on an annualized basis. The expression
"annualized basis" here means that if the same money were invested at the
same rate of return for the whole year, the return would equal 15 percent
of the money invested.

HDwever , since the life of any listed option is nine months or
less, one cannot assume that funds invested in listed options can be
reinvested at the same rate of return three, six, or nine months later.
Interest rates, transaction costs and, of course, premium levels are
all subject to change. Therefore, any annualized rate of return relating
to options is misleading if the basis for the extrapolation is not disclosed,

Tb take an extreme hypothetical example, the purchase of an
out-of-the-money call option for 50 cents at the beginning of a month
and the sale of the option for $1.00 at the end of the month could yield
a 100 oercent return on investment (disregarding all transaction costs) .

390

However, to tell the investor that this transaction would yield 1,200
oercent on an annualized basis could be very misleading unless the
customer were also told of the impact of transaction costs and of the
virtual imrossibility that this trade could be executed twelve consecutive
times in a similarly profitable manner.

Fbr these reasons, some professionals in the industry view the
practice of expressing options investments in annualized terms as
inherently fraudulent or, at best, meaningless. Other professionals
arque that annualized rates of return are the only way that an investor
can easily measure and compare the profitability of an options investment
to another investment opportunity. For instance, the yield on bank
savings accounts, treasury bills and other debt instruments is usually
exoressed in annualized terms. Some options professionals believe
that the competitive pressure from these other investment opportunities
mandates the use of annualized returns to describe options transactions
or strateqies. Che options salesman stated the competitive realities
succinctly: "...to get the business, you have to say something
[reqardinq rates of return] ."

Whatever the merits of annual ization, the use of annualized
returns to describe the profitability of proposed options transactions,
without disclosure of all underlying assumptions, is misleading to
investors. Che brokerage firm recently attempted to deal with the
problem of such disclosure by disseminating to its branch managers

391

a memorandum which suqqested that the following admonition be given

to customers whenever annualized rates were mentioned:

Use of annualized rates of return makes it easier
to compare different strategies involving different
durations. It does not imply, however, that the investor
will realize the described rate over a period as great as
one year or that transactions entered into after the
suagested investment position is liquidated would
produce comDarable rates of return.

This same firm has also included on its options worksheet a disclaimer

concerninq the likelihood that a specific trade would achieve the

annualized rate set out on the worksheet.

Not all disclaimers, however, adeauately inform customers of the

assumptions implicit in annual izat ion. In fact, some serve to further

mislead investors by disclaiming unrealistic assumptions:

Our mathematical models suggest positions that should
normallv appreciate between 10% and 25% annually. These
rates cannot, of course, be guaranteed. However, unless
the particular corporation appears to be going bankrupt
or a national catastrophe occurs, there is normally a very
small risk.

c. Other problems with the use of rates of return

In addition to being exaggerated and misleading, annualized rate

of return fiqures, when used in promotional materials for options, are

troublesome for other reasons.

( 1) Misleading calculations

Since the rate of return figure is freauently the major device

used to gain the interest of customers in various types of promotional

392

materials, the computation which establishes the return figure should

be done correctly. Ffowever , the Options Study has reviewed several

promotional documents where the figures simply were wrong. Even the

CBOE reference manual, described by the CBOE as a "valuable tool

for the registered representative as he endeavors to present the option

concept to the investment public", contains a prominent rate of return

computation which is incorrect.

The CBOE attempted to show why an investor contemplating a

$5,000 stock investment should consider a combined investment in both

options and short-term money market instruments, where $500 would be

committed to options and the remaining $4,500 to the short-term money

market paper. Ihe error resulted because the investor's return on the

entire $5,000 investment was expressed instead as a percentage of the

$500 committed to options. The CBOE's example is as follows:

[A]n AT 50 call option might have been purchased
six months prior to expiration, when the stock was at
50 and the option was selling for 5. At the same time,
the remaining funds [$4,475] might have been invested
in a short-term money market investment yielding 5%.
If, at expiration, [six months later] the stock had
appreciated in value to 60, the option might be sell-
ing at its intrinsic value of 10.

Cost:

Proceeds:

393

$ 500 Option premium

+ 25 Commission

$ 525 Total cost

$1,000 Sale of option

- 40 Commission

$ 96i0" Total option proceeds

+ 112 5% on $4,475 invested
$1,072 Total proceeds

$1,072 Proceeds

- 525 Cost

$ 54~7 Net orofit (104% on the original investment)

In reality, the "net profit" of $547 represents not 104 percent, but
less than 11 percent of the total original investment of $5,000.

(2) Failure to include transaction costs

The accuracy of any rate of return figure is significantly affected
by brokerage commissions, interest charges, and other transaction costs.
Yet, since emission of these figures simplifies the computations, promo-
tional literature, even that produced by one of the options exchanges,
does not always include transaction costs when calculating rates of
return. Tb ignore these costs, however, can result in rate of return
computations misleading to the public investor.

(3) Distorted presentations

Another practice in the industry is to portray rates of return
in percentage figures (which generally are more impressive than dol-
lar fiqures) for gains, but almost never to portray losses in percen-
tage fiqures. Potential losses are discussed, if at all, in absolute

394

dollar figures. To give a hypothetical example, if an investor bought

an option for 50 cents, and sold the option for $1.00, most promotional

literature would call his result a 100 percent return. However, if

the investor lost the 50 cents, that is, if the option became worthless,

the literature would not say that the investor had lost 100 percent

of his investment. Instead, the investor would be said to have suffered

a loss of "only 50 cents" or a loss "limited to 50 cents."

The "strategies" chapter of the AMEX's 1977 "A Guide to Listed
Ctotions" exemplifies the practice of expressing gains as percentages
but losses in dollar figures. Eighteen times in that chapter a
computation of gains is offered. In ten of those instances, gains
are expressed in percentage terms; in eiaht of those instances
gains are expressed in absolute dollar terms only. On the other
hand, while the possibility of loss is mentioned thirty times
in the same chapter , only once are losses expressed as a percentage
of investment, with losses expressed in absolute dollar terms twenty-
nine times.

3. Predictions, Promises and Guarantees

a. Predictions without a reasonable basis

The use of exaggerated rate of return figures to promote and sell
options is often accompanied by actual or subtle suggestions that the
designated return is a predictable result of a proposed options investment,

395

The Commission has long held that a registered representative must
have a reasonable basis for any recommendation he makes or opinion he
expresses about a security since "groundless opinions came within the
ambit of false and misleading statements prohibited by the securities
laws." 31/ Predictions of earnings for speculative securities have been
considered inherently misleading unless accompanied by "full disclosure
of both the facts upon which they are based and the attendant uncertain-
ties." 32/

The Options Studv has encountered numerous instances in which a
registered representative's opinion as to the anticipated rate of return
for an options transaction or strategy, although expressed with the
authority and conviction of a prediction, had no reasonable basis. When
asked to justify their opinions, registered representatives sometimes
admit that they have no basis for the opinion or else respond with only
vaque generalities. One registered representative indicated that her
"objective" of achieving a "20-30% consistent annual return" for customers
in options tradina was based upon her knowledge of a seven-year market
cycle. Ftowever , she could not explain how to relate this cycle to the
listed options markets which has existed only since 1973. Mother registered

31/ Alexander Reid & Co., 40 SEC 986 (1962).

32/ Richard J. Buck & Co., 43 SEC 998, 1006 (1968), aff 'd sub nom.
Hanley v. SEC, 415 F.2d 589 (2d Cir . 1969).

396

representative told his customers that they could expect between 15 and
20 percent annualized returns with minimal risks. Although he based this
prediction upon his "general feeling for the performance of accounts"
he had seen, he could not specifically identify for Commission investigators
any account in which such returns had been achieved. Cne registered
representative testified that he felt his representation to customers
of a 25 oercent return in options was "conservative" based upon statements
by the firm's options coordinator that certain accounts in the firm had
returned as high as 40 percent. Another registered representative solicited
options customers with representations of returns as high as 15 percent,
although he admitted that he had never seen an options account return
that much.

One registered representative testified that he solicited potential
options customers by presenting a 25 percent yearly rate of return as a
tarqet which he hoped to achieve through options. Several of his customers
claimed that he had premised them even larger annual returns, in some
cases ranging up to 500 percent. The Commission's staff analyzed this
registered representative's customer options accounts for the period
covering the bulk of his options trading activity and found that only
three of 40 accounts were profitable, that customer losses aggregated
$292,000, and that the average account lost 24 percent of the equity
invested, with commissions comprising 67 percent of those losses.

397

Similarly, by using pseudo-scientific articles and a newsletter,

one broker-advisor team qave potential customers the impression that it

could scientifically predict results for customers participating in the

team's options trading program. The team claimed that no account managed

bv the advisor had ever lost money. In addition, a published article

authored bv the advisor , which claimed that accounts under management had

averaqed more than a 10 percent return annually over the past several

years, was reDrinted and distributed to potential clients. When asked

for the basis of the 10 percent figure used in this article, the advisor

could onlv respond:

It is common and accepted practice in this [academic]
society and others to publish figures and not too extensive
computations relating to those figures.

Later , the advisor admitted having no records to substantiate his claims
concerning the profitability of clients' options accounts except for
records of one calendar quarter during which 21 of the 49 managed accounts
actually had experienced a decrease in net asset value.

Another team of salesmen told their customers that they were able
to predict the profitability of proposed options transactions by means
of a "scientific system" which they compared to short-term weather fore-
casting. Their profitability forecasts, however, were cloudy and invariably
wrong .

40-940 O - 79 - 28

398

b. Objective versus guarantee

The emphasis in many of the materials used to promote and sell op-
tions is on achieving an attractive rate of return with a minimum of risk.
Given these optimistic promotional efforts, statements made to customers
bv their registered representatives about the profitability of options
often mislead investors into believing a risk-free return is predicted,
promised, or even guaranteed.

Some investors claim to have been told that they would "almost
definitely" receive a favorable rate of return from options trading;
others claim that specific returns have been guaranteed outright.
Even when representations are phrased as "objectives" , "goals" or
reasonable targets for profitability, investors often believe that
they have been promised a particular rate of return. Investors
typically are told that options have a profit potential of 12 percent
to 14 percent; that an options program can produce "a 20-30% consistent
annual return"; that options trading is "expected to produce" a given
rate of return; or that certain options trading strategies or programs
are "lucrative". In one instance, an investor was told that options
trading is the same as having "someone throwing quarters at you."

When representations of this type are coupled with statements
which minimize the risk of loss, the investor can understandably
believe that he is being promised a favorable rate of return.

399

Some reqistered representatives have told customers that options
were a "guaranteed way to make qood" and that the customer "couldn't
lose." One reqistered representative claimed he had a "foolproof
formula", complete with eouations, which demonstrated how a customer
could make "large profits of 35 percent without possibility of
loss."

Althouqh reqistered representatives usually deny promising any
customer a profit, the Options Study has identified several situations
in which options customers have been given outright guarantees. For
instance, one registered representative guaranteed to his customer,
in writing, that the customer's losses would not exceed $2,000 from
trading options in three months. He renewed this guarantee each
three months for a nine month period. The registered representative
signed his guarantee on behalf of the brokerage firm, telling
his customer that the firm would honor the written guarantee.
The customer incurred substantial losses and the guarantee proved
worthless. The same registered representative offered a comparable
guarantee to another of his customers. Similarly, another registered
representative Drovided a customer with a written guarantee which assured
the customer a 50 percent return in only four months. In still another
instance, a registered representative deposited funds in a customer's
account as part of an arrangement with the customer to guarantee the
customer against loss. On occasion, the Commission's examiners have

400

also found indications that certain registered representatives selling
options were guaranteeing customers against unprofitable transactions
by regularly transferring such transactions from customer accounts to
the firm's error account. Guaranteeing customer transactions against
loss is expressly prohibited by exchange rules. 33/

4. Controls

The following table sets out firm policies of the industry group
sample concerning price predictions, predictions of return on investment
and guarantees:

YES NO NO ANSWER

Firm has a policy applicable 73% 25% 2%

to options prohibiting sales
persons making price predictions
to customers

Finn has a policy applicable 62% 38% —

to options prohibiting sales

persons making predictions

of return on investment to

customers

Firm has a policy applicable 98% 2% —

to options prohibiting sales

persons making guarantees of

return on investment to

customers

33/ E\g_. , Rule 9.18, CBOE GUIDE (CCH) II 2318.

401

To monitor these policies, most firms review correspondence and
customer complaints and rely on the integrity and professionalism of
their sales force. Such controls have not been effective in preventing
abuse or in protecting investors.

Of the firms in the industry group sample, 52 percent allow
salespersons to use annualized rates of return when discussing the
profitability of options transactions with options customers. Although
manv of these firms discourage or limit the use of annualized returns
in some manner, most have no effective means for monitoring compliance
with their restrictions. 34/

The Options Study recommends :

THE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND THEIR
OPTIONS RULES TO REQUIRE (1) THAT WHENEVER RATES OF RETURN
ARE CALCULATED FOR DISCLOSURE TO INVESTORS, ALL RELEVANT
COSTS MUST BE INCLUDED IN THE COMPUTATION; AND (2)
THAT WHENEVER ANNUALIZED RETURNS ARE USED TO EXPRESS THE
PROFITABILITY OF AN OPTIONS TRANSACTION, ALL MATERIAL
ASSUMPTIONS IN THE PROCESS OF ANNUALIZING MUST BE DISCLOSED
TO THE INVESTOR AND A WRITTEN RECORD OF ANY RATE QUOTED
TO A CUSTOMER MUST BE KEPT.

34/ The self -regulatory organizations also have regulations which
attempt to circumscribe the use of rates of return by brokerage
firms in advertising and sales literature. The industry's recently
promulgated uniform guidelines for advertising and sales literature
are a beginning in the regulatory effort to control some of the
problems arising from the use of annualized rates of return to
describe the profitability of options transactions. These guidelines
generally provide that annualized rates of return, when used, must
be accompanied by a description of their means of calculation as
well as the assumptions underlying the annual ization process.

402

F. PROMOTING OPTIONS - SPECIFIC METHODS.

1. Advertisements and Sales Literature

Advertisements and sales literature generally represent a brokerage
firm's most formal and "official" efforts at promoting and informing
customers about options. Unlike worksheets, performance reports and other
ad hoc promotional efforts of individual branch offices or salespersons,
advertisements and sales literature are usually produced by the firm's
headquarters office and bear the official stamp of approval from management.

The Options Study's review of a sampling of advertisements and sales
literature revealed that promotional styles differ among firms, and even
within the same firm from time to time, and that these styles vary from
low-key to aggressive. The materials seen by the Options Study primarily
were those filed with the self-regulatory organizations for review or
approval. Although many of these materials seemed unobjectionable, cer-
tain problems were identified. These problems continue to be of concern
since some salespersons and firms sometimes neglect to file advertising
materials for review as required by exchange rules. 35/
a. Promises of attractive returns

As noted earlier, the holding out of attractive returns on investment
is a recurring theme in promotional programs of brokerage firms. As also

35/ E.g., Rule 9.21, CBOE GUIDE (CCH) 11 2321; Rule 483, 2 ASE GUIDE
(CCH) 11 9494. See Chapter VI.

403

noted, customers often believe that they have been "promised" these

attractive returns if they decide to invest in options. The Options Study

has found that promises of successful results are implicit in many of

the advertisina and sales literature documents it reviewed. These "promises"

are particularly significant because they are conveyed to a customer,

not by salesoersons, but through materials issued by the firm itself.

If these materials make exaggerated or unrealistic claims about options,

these claims will not only mislead the public directly, but they also

will indicate to the firm's sales force that the firm approves of similarly

exaoqerated claims in oresentations made by registered representatives

in direct contact with customers.

The following are a few examples from advertisements or sales literature

reviewed by the Ootions Study which seem to make or imply promises that

favorable results will usually flow from options trading:

. "Would you be interested in receiving 15 to 20% annual income
from the stocks you now own?" March 1976. [The CBGE changed
"receiving 15-20%" to "up to 15-20%". A year later, on recon-
sideration, the CBOE required the firm to delete the reference
to specific numbers and to simply use the language "an attractive
return."]

. "Don't expect to triple your money using options . . .15%

is our goal." April 1976. [Large bold-print advertisement,

withdrawn after several months use when the CBOE retracted its
approval . ]

. "Tempted? Come on in. Everybody loves a 10%-12% yield."
September, 1977. [Promotional Letter.]

404

"... why settle for 9%, if there is the opportunity to achieve
siqnificantly more with limited risk?" [Promotional letter
to "qualified clients and prospects," to be accompanied by
an OCC Prospectus.] February, 1978.

"If your firm has a qualified pension plan of any type, for
the benefit of you or your employees, I would like the oppor-
tunity to outline an investment concept that is an alternative
to fixed income securities with a substantially qreater percent
return. Tne main features of this investment are:

- Short term market exposure, less than 9 months.

- Liquid it v

- Returns of 10-16% on net investment...."
[Promotional letter.] March, 1977.

Many of these advertisements emphasize the possible rewards of options
tradinq without adequately discussing the corresponding risks, in clear
contravention of exchange rules which require a balanced presentation. 36/
b. Touting the "Expert"

Another promotional theme found in advertisements and sales liter-
ature which is somewhat related to the problem of promises and predictions,
is the touting of the firm's in-house options "expert" or expertise. A
number of firms also claim to have a special formula or computer program
desiqned to help the options "expert" achieve favorable results for options
customers. For example, one firm has an "Oasis-5 stock sensitivity program"
another has the "Peroni system". Another firm attempted to promote one
of its employees as a "well-known options advisor to CBOE, AMEX, member
of the Board of Directors of the Options Clearing Corporation....", but

36/ E.g., Rule 9. 21. 01. II. A, CBOE GUIDE (CCH) f 2321.

405

was forced to modify the language on the insistence of the options exchanges.
And one firm claims to have "one of the most sophisticated options programs
in the country."

These claims are easily made because, in general, brokerage firms
have not been required to document the success of their programs or formulas,
or to demonstrate the exDertise of their "expert". Even the ROP examination
is not desiqned to do more than test for a minimum basic understanding
of the mechanics of listed options.

Since a common complaint of options customers is that they did not
understand options, and were induced to invest in options only after receiving
assurances that they could rely on the proclaimed expertise and special
capabilities of a brokerage firm and its options experts, the Options
Study is particularly concerned about management-sanctioned advertisements
which create an impression that an options "expert" or options expertise
is indeed available at the firm.

Therefore, the Options Study recommends:

THE RULES OF THE SELF-REGULATORY ORGANIZATIONS
SHOULD BE AMENDED TO REQUIRE THAT MEMBER FIRMS
MAKE AVAILABLE FOR PUBLIC INSPECTION UNEQUIVOCAL
AND COMPREHENSIVE EVIDENCE TO SUPPORT ANY CLAIMS
MADE ON BEHALF OF OPTIONS "PROGRAMS" OR THE OPTIONS
"EXPERTISE" OF SALESPERSONS.

c. Flamboyant language

The complexity of options as an investment vehicle makes them an

inappropriate subject for aggressive or "hard sell" techniques. Yet,

406

the Options Study found a disturbing number of options advertisements of

Questionable taste and veracity. While issues of tone and taste may be

matters of individual preference, the rules of the options exchanges plainly

prohibit use of promotional materials which are misleading or which

fail "to meet general standards of good taste and judgment common

to the securities industry." 37/ The following are a few examples

of promotional statements which seem to have both qualities:

. "Do you want more mileage from your commission dollars?"
March 1976.

"Would you like to buy stock at an effective price below current
market using Options?" March 1976.

"learn how you may buy stocks below the current market price
- and also be paid a premium." October 1977. [The CBOE changed
"how you may buy" to "how it is possible to buy" and struck out
references to a premium. ]

. "How to make money by buying and selling options on the same
stock at the same price." October 1977. [The CBOE changed
"How to" to "learn how you might...."]

There is a magical tone to these statements. In fact, the last

example above continued: "No we're not pulling your leg." Another firm's

oroposed advertisement began "Believe it or not..." If materials produced

by the broker aqe firm foster the impression that options work in mysterious

but marvelous ways, the customer is left either without information, or

worse, with misinformation about options.

37/ See, e.g., Rule 9.21(b)( iii) , CBOE GUIDE (CCH) 1| 2321. Tne other
options exchanges have similar rules.

407

2. Seminars

Seminars are a popular technique for attracting and educating options
customers. Firms use various labels to describe seminars — e.g. "clinic"
or "forum" — and same seminars are purportedly designed to reach only
" sophisticated" or "experienced" options investors. A few firms
occasionally go so far as to charge a fee for a seminar , which is sometimes
then labeled a "course."

In most cases, brokerage firms do not provide the texts of options
seminars to the options exchanges in advance, since advance review of
materials is required only for mass media materials. However, mass media
advertisements for options seminars must be cleared by the exchanges,
and the content of the seminars must conform to general exchange rules
which reouire truthfulness and good taste in communications with the
oubl ic .

Because seminars are advertised as primarily educational — and not
Dromotional — meetings, they evoke an image of a balanced presentation
of the advantages and disadvantages of using options in investment programs.
The texts of the few seminars that have been reviewed by the Options Study,
however , reveal that seminars can be far from the balanced presentations
they often purport to be , and rather , may be simply another means used
by a firm for attracting options customers. As such, they contain the
same promotional bias that characterizes other forms of advertising.

408

The presentation of one national broker-dealer firm's series of
seminars, featuring the "[Name] System" of options investment, exemplifies
this problem. This "system" — described as a "high yield; low risk
investment concept" — was essentially a covered options writing program
to which the " [Name] System" was supposed to provide "added protection
and profit potential". Audiences were told that the system featured:

. "Risk reduction"

. "Earning the time premium"

. "Management of the portfolio"

. "Net yield of 18-20 percent"
The audience was further informed that a properly managed covered
writing program would increase the odds of investment success by 3 to
1 over the investor who remained a "non-writer". These odds were derived
from a "computer analysis" of stock market performance over a twelve
year period."

To reinforce the audience's belief in the success of the "system",
an example of a profitable covered writing investment was described,
complete with attractive annualized rates of return on investment.
The audience was told that, by carefully choosing the stock and monitoring
the stock-option position, a writer could enjoy attractive gains in either
an uo or down market. All examples seem to have been selected carefully to
ensure a favorable and predictable result.

409

The " [Name] System" seminars were conducted from mid-1976 until

February 1978, when the text of the presentation finally came to the

attention of the CBOE. The CBOE promptly objected to the contents,

finding that the presentation was "unbalanced in terms of risk and

ootential reward," and that it:

. fail[ed] to address the subject of suitability;

. frequently quo t[ed] ... rather inflated
theoretically attainable annualized rates
of return, [without making any] attempt
to explain how the figures were derived;

. contain [ed] implied guarantees and other
oromissory language.

The broker-dealer firm was thus forced to revise the text of the
seminar two years after the seminar was first presented to the public.
The revisions were not finally approved by the CBOE until April 1978.

Another firm's seminar script reviewed by the Options Study
suggested that the "harsh choice" facing an investor who confronted
the "bad news" of inflation (depicted as a large fierce monster devouring
money) was to "either cut back on living standards or look for new
ways to boost [his] investment yield past that 8.2% inflation line."
The "good news" was the availability of a "little-known way to possibly
out-race inflation without taking on a lot of risk ..." And the way
was: "option writing for more income now." (Emphasis in original.)

410

The presentation used evocative words designed to promote options.
Tne hypothetical stock chosen for purchase in the covered writing example
was called "Superior Company" , and the investor "who didn't believe in
options" was named "Mr. Lackluster". (Tne AMEX insisted that the name
be changed to "Mr. Jones".) The first covered writing example provided
the investor with a 14 percent annualized return and subsequent hypothetical
examples showed the options writer almost always faring better than
the mere stock purchaser. Tne one exception occurred when Superior's
stock "sho[t] up" beyond the strike price. In that case, "the buyer
would [have] exercise [d] his option and [the covered writer] would [have]
miss[ed] out on all the gain above the striking price ...." However,
the covered writer "would come out ahead in the three out of four situations
we've been seeing most often in the market."

Brokeraqe firms unquestionably have the right to promote the sale of
securities — including options — through various promotional devices,
including seminars. However, firms should not be permitted to engage in
sales promotions under the guise of offering an educational service.

Accordingly, the Options Study recommends:

(1) THE RULES OF THE SELF -REGULATORY ORGANIZATIONS
SHOULD BE AMENDED TO REQUIRE THAT WHEN MEMBER
FIFMS USE SEMINARS TO PROMOTE OPTIONS, THEY
MAKE THE FOLLOWING DISCLOSURES TO THOSE ATTENDING:

411

—IF THE "LECTURER" IN THE SEMINAR IS A

BROKERAGE FIRM EMPLOYEE COMPENSATED IN WHOLE
OR PARI' BY COMMISSIONS, AND IS USING THE SEMINAR
TECHNIQUE TO ATTRACT CUSTOMERS, HIS FINANCIAL
INTEREST IN THE ACOUISTION OF CUSTOMERS FROM
THE AUDIENCE SHOULD BE DISCLOSED;

—IF A "PROGRAM" OR "SYSTEM" DESCRIBED IN THE
SEMINAR IS ALREADY IN USE, THE CUMULATIVE
EXPEKIENCE OF THE PROGRAM'S PARiTCIPANTS SHOULD
Lit: FULLY DISCLOSED AND DOCUMENTED, AND
THE AUDIENCE SHOULD tfE WARNED THAT PAST
RESULTS ARE NO MEASURE OF FUTURE PERFORMANCE ;

—IF THE PROGRAM IS TOO NEW TO HAVE A PERFORMANCE
HISTORY, THE AUDIENCE SHOULD BE FULLY APPRISED
OF THE UNTRIED NATURE OF THE PROGRAM.

(2) SELF-REGULATORY ORGANIZATIONS SHOULD DEVELOP A PROGRAM
IN WHICH SURPRISE ATTENDANCE AT SEMINARS FORMS PARI OF
'THEIR OVERALL INSPECTION PROGRAM RELATING TO OPTIONS
SAUjS PRACTICES.

3. worxsneets and Performance Reports

WorJcsneets portray the profit potential of proposed options trans-
actions and are wiaeiy used throughout the securities industry to depict
trie potential risJcs and returns of proposed transactions to customers.
Tney are used Doth in face- to- face sales presentations between customers
and registered representatives and are sometimes sent to customers to
solicit tneir participation in particular options transactions.

worksheets can oe adapted to portray the risk and return possibilities
or nost types of options transactions, but the Options Study found them
used most frequently in conjunction with recommendations concerning

412

covered call writing strategies. A typical worksheet for a covered call

writing transaction would show the maximum potential returns available

to an investor if the underlying stock were called away from the investor

(that is, if the holder of the option exercised the option), and if the

stock were not called away (that is, if the option were not exercised).

Some covered writing worksheets also include a calculation of a "break-even

point" for the proposed transaction.

Some firms prohibit the use of worksheets, while other firms limit

their use. The following table sets out the policies of firms in the

industry group sample with regard to showing or sending worksheets to

customers.

Existing Ebtential

Customers Customers

Pegistered repre-
sentatives may show 72% 63%
worksheets to:

Registered repre-
sentatives may send 61% 53%
worksheets to:

As distinguished from worksheets, which present for options customers
the profit of potential transactions, "performance reports" purport to
analyze the results of actual options transactions. Two types of options
performance reports are commonly used in the brokerage industry: (1) a
report of realized or unrealized gain or loss in a customer's account
resulting from a single options transaction or series of options trans-
actions; and (2) a report containing a similar analysis over a specific

413

time period of the customer's entire portfolio or of his options
Dortfolio alone. The typical options performance report is generally
a statement of profit and loss. It may serve to supplement, and if
properly done, help translate, the periodic customer account statements
which are often difficult to understand.

In addition to serving as supplements to the periodic account
statements, performance reports may be used as selling documents,
and shown to potential customers to solicit new options business.
The successful experience of actual customers can be an extremely
effective inducement to potential customers considering options
as an investment.

The table below sets out the policies of firms in the industry
qroup sample with reqard to use of performance reports:

Cwner of
Account

Prospective
Customers

Allow computer generated
reports to be shown to:

Allow reports other than
computer aenerated to be
shown to:

28%

54%

Thirty-eiqht percent of the industry group sample prohibits the
use of performance reports by registered representatives altogether

40-940 O - 79 - 29

414

Both worksheets and performance reports are generally prepared
by individual registered representatives, although, in the case
of worksheets, the brokerage firm may supply the format on which the
registered representative fills in numbers to illustrate a transaction.
If used correctly, both performance reports and worksheets can furnish
useful information to existing or potential customers. However, the
Options Study has found that as with other promotional materials,
worksheets and performance reports too often are used in a manner
unfair to investors.

a. Exaggerated returns

Unreal istically high rates of return are often depicted in worksheets.

It is not uncommon to see worksheets indicating available returns of up

to 30 percent. Che registered representative used for sales presentations,

and later sent to one of his customers, a worksheet which quoted returns

of between 43.1 percent and 73.2 percent. This same worksheet stated:

IF YOU FIND THIS KIND OF RETURN APPEALING TO

YOU PLEASE CALL ME AND I WILL BE HAPPY TO

TAKE ALL THE TIME NEEDED TO EXPLAIN. (Emphasis in

original.)

Still another registered representative used worksheets which "showed

potential qains of up to 189 percent on proposed options transactions.

Given these extraordinary results, the terminology found on one sheet,

in which the options writer is called the "banker" (and the purchaser,

the "gambler"), seems understated.

415

Exaggerated return figures are found in worksheets for several
reasons. A frequent reason is the omission of certain transactions
costs such as commissions and interest costs, which can have significant
impact on the profitability of an options transaction,
b. Selective reporting

The Options Study has also found worksheets in which return
figures seemed attractive because the presentation showed only the
most profitable possible results and omitted disclosure of the less
profitable possibilities for the recommended transaction. In contrast,
the Ootions Study did not encounter a single instance in which any
anticipated dividend — which would increase the profitability of the
transaction — was omitted from an options worksheet computation.

Worksheets also often ignore the possibility of loss which might
came about because of a decline in the price of the underlying stock,
particularly with respect to covered call writing strategies. For
instance, one worksheet form used by registered representatives
in several major firms to describe covered writing situations sets
forth the following:

PERCENTAGE RETURN ON SELLING OPTIONS

If Stock Is Called If Stock Is Not Called

(Assume stock remains at current price)

416

The two assumptions presented would generally result only in profit
to the customer (provided that the sum of the options premium and any
stock dividends received is greater than all commission costs incurred) .
Nd mention is made of possible declines in stock price, which can result
in loss to the customer .

A different kind of selective presentation can distort results when
performance reports are used as selling tools as, for example, if only
the results of successful accounts are shown to prospective customers
while accounts showing losses are not shown,
c. Erroneous calculations
Exaggerated figures may also come about because of errors in
calculation. Worksheets and performance reports are usually prepared
by individual registered representatives, not by management, and they
are error-prone. The Options Study has encountered several situations
in which registered representatives prepared either worksheets
or performance reports that contained errors. These errors almost
always inflated the profitability of a proposed transaction or of
a customer's account. For example, the Options Study reviewed one
worksheet in which a registered representative computed the customer's
commission costs in the proposed transaction as additional income to
the customer .

When erroneous or inaccurate return computations are found in a
performance report both the customer whose account has been "analyzed"

417

and prospective customers who are shown the report may be misled.
An example of the or obi ems which may arise when performance
reports are miscalculated and then used as a sales tool is found
in the activities of an options sales team operating in the branch
office of a maior retail brokerage firm.

Initially, the sales team solicited four customers to participate
in a "pilot Droqram" of options investment. After several months of
options trading, the accounts of these four "pilot" customers were
analyzed for performance by the sales team. One of the registered
representatives calculated the following favorable returns on investment
for the various types of strategies used in the "pilot program":

(1) Agqressive Call Buying 7 mos. 23.59%

(Annualized ) 40. 44%

(2) Agqressive Covered Writing 7 mos. 35.06%

(Annualized) 60.09%

(3) Conservative Covered Writing 7 mos. 22.09%

(Annualized) 37.87%

These figures were false, tone of the four customers involved
in the "pilot program" earned these rates of return. In fact, one of
the customers lost $4,280 during his involvement in the program, and
another customer earned only $3.54 on an $8,100 investment. The other
two participants earned only a 3 percent return on their original investment
In addition, none of these customers participated in the "pilot program"
for the full seven months as depicted in the reports.

418

These incorrect reports were given to the customers involved
in the "pilot program" and subsequently were used as promotional
materials to solicit new options customers at a series of seminars
conducted by the sales team. Many of these new customers were led
to believe that they would enjoy comparable returns if they par-
ticipated in the sales team's new "managed options program."

As a service for certain of these new options customers, the sales
team also prepared periodic performance reports which purported to
reflect all the transactions that had occurred in each customer's
account during the period reported upon, along with the profits and
losses incurred as a result of those transactions. All of the reports
were inaccurate; they generally inflated the equity value of the customer's
account and reflected profits when, in fact, losses had occurred.
The following table sets out the reports sent to customers - and
the corrected figures :

Reported

Actual

Equity

Customer's

Profits

Reported to

Actual

Customer

Month

(Losses)

Customer

Equity

June, 1977

$ 479

($ 5,104)

$10,201

$ 2,204

June, 1977

4,230

( 11,361)

34,730

6,409

June, 1977

2,921

( 3,616)

35,203

3,265

June, 1977

2,850

( 6,224)

21,185

12,200

March, 1977

( 450)

9,670

9,935

June, 1977

885

( 3,582)

13,985

14,243

March, 1977

175

( 1,506)

4,200

2,122

June , 1977

3,608

( 1,783)

13,960

6,534

June, 1977

964

( 3,438)

No Report

March, 1977

759

( 4,896)

11,900

6,833

419

d. Deceptive timing

Performance reports, to be useful to a customer, must contain current
information since fluctuation in stock or options prices can dramatically
alter the results of options trading. Therefore, information which is
not current can be as misleading to the options investor as erroneous
information. The Cot ions Study encountered some performance reports,
however, which included information about a customer's account which
was not current. In one instance, a report that was only one week
out-of-date told the customer that he "should probably realize . . .
S4,500 as Drofit for the coming quarter," when, in fact, because of
movements in stock orices and transactions after the date of the report,
the customer had already lost or was in danger of losing almost all of
the $4,500 "profits" by the time he received the report.

e. Controls

(1) Standardized forms
A serious shortcoming with regard to options worksheets is the
absence of a standardized format throughout the securities industry and
even within firms. Worksheet forms created on an individual basis
by reqistered representatives are more likely to contain arithmetic
errors and to have serious disclosure deficiencies than those provided
by the brokerage firm. In addition, lack of a standardized format
increases the difficulty of analyzing a worksheet for supervisory
Dur poses .

420

Almost half of the firms in the industry group sample already provide
some sort of standard form options worksheet for use by their registered
representatives althouqh not all firms require use of the standardized
form. Several firms provide worksheets for registered representatives
but mark those forms "FOR INTERNAL USE ONLY" or "NOT FOR DISTRIBUTION
OUTSIDE OUR FIRM." Making standardized forms available to registered re-
presentatives is an insufficient control device, however, if registered
representatives, nevertheless, are permitted to use their own options
worksheet forms. In one firm which provided standard form worksheets
for internal use only, certain registered representatives sent to customers
other options worksheets which were never shown to any supervisor of
the firm and which gave customers the impression that the options trades
described were "no-lose" situations.

A standard form worksheet which provides an organized presentation
of all information and disclosures relevant to an options transaction
and which is uniform throughout the industry would help both investors
and registered representatives understand the precise nature of the
options transaction being proposed and, at the same time, provide a basis
for prompt audit by the firm or regulators.

421

Accord inqly, the Options Study recommends:

TOE SELF -REGULATORY ORGANIZATIONS SHOULD (1) DEVELOP
UNIFOFM STANDARDIZED OPTIONS WORKSHEET FOFMS WHICH
REQUIRE DISCLOSURE OF ALL RELEVANT COSTS AND OTHER
INFOFMATION, INCLUDING AN APPROPRIATE DISCUSSION
OF TOE RISKS INVOLVED IN PROPOSED TRANSACTIONS;
(2) PROHIBIT THE USE OF ANY OPTIONS WORKSHEETS
OTHER THAN THE NEW UNIFORM FORMATS AND REQUIRE
THAT NEW WORKSHEETS BE FULLY COMPLETED WHENEVER
USED.

Performance reports created by registered representatives on an
individual basis can likewise be confusing, misleading, incorrect,
and difficult to audit. Most firms in the industry group sample
rely almost entirely on correspondence reviews to monitor the use of
performance reports. However, simple correspondence review procedures
are not adeouate to deal with the potential problems to customers
caused by performance reports. What is called for is detailed financial
analysis to evaluate these reports for fairness and accuracy which
many supervisors have neither the time nor the expertise to perform.
Moreover, many brokerage firms do not provide their sales office
suDervisors with the information or assistance necessary to accomplish
such an analysis on a reasonably prompt basis.

In all of the cases involving misuse of performance reports
reviewed by the Options Study, the brokerage firm did not have effective
controls to monitor a registered representative's use of performance
reports. One solution to the problem of ad hoc performance reports
is to produce some form of computerized performance report for

422

individual customer accounts. Eighteen percent of the industry
qrouo sample follow this practice. Even though these computerized
reports may be misused by particular registered representatives,
they appear to offer some protection to customers by eliminating
the erroneous calculations so likely to occur when performance
reports are prepared bv individual registered representatives.
Computerized reports also introduce a degree of standardization
which facilitates supervisory review.

(2) Recordkeeping and inspection of worksheets
In order to properly monitor the use of options worksheets, firms
must have adeouate record retention procedures. Frequently, however,
neither options worksheets prepared for "internal use" nor those shown
or sent to customers are kept as part of the firm's permanent records.
Eiqhty-seven percent of the industry group sample indicated that they
do not reauire registered representatives to keep copies of options
worksheets shown to customers and 65 percent do not specifically
reauire retention of worksheets sent to customers. Even those firms
which reauire retention of worksheets do not always insist that
they be kept for an adequate period of time. When options worksheets are
retained, they are most commonly kept as part of a branch office's
general correspondence file where they are difficult to retrieve
and collate with other documents for analysis of trading in an options
customer's account.

423

In view of the problems discovered concerning the use of options

worksheets, the Options Study recommends:

THE SELF-RECULATORY ORGANIZATIONS SHOULD REQUIRE
THAT COPIES OF ALL OPTIONS WORKSHEETS WHICH ARE
SHOWN OR SENT TO EXISTING OR PROSPECTIVE CUSTOMERS
OR WHICH ARE USED AS THE BASIS FOR ANY SALES PRE-
SENTATION TO A CUSTOMER BE RETAINED BY MEMBER
FIRMS FOR AN APPROPRIATE TIME IN A SEPARATE
FILE IN THE SALES OFFICE IN WHICH THE CUSTOMER
HAS AN ACCOUNT.

Record retention procedures can also help control the use of
oerformance reports. Several firms already require that all performance
reports be keot permanently but most firms require only that all
performance reports be retained for three years or less. Inspections
conducted bv the Commission's staff indicate, however, that even when
oerformance reports are kept, they are sometimes buried in miscellaneous
correspondence files and are, thus, not available for easy and prompt
examination in connection with the analysis of a customer's account.

Because the popularity of performance reports can be attributed, in
part, to the inadeouacies of regular options account statements, im-
plementation of the Options Study's recommendations with respect to
improving such statements may make the use of performance reports
less attractive to registered representatives. Nonetheless performance
reports probably will continue to be used as a sales device. The procedures
recommended below may alleviate the problems with performance reports
identified bv the Options Study.

424

The Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND
THEIR RULES TO REQUIRE THAT:

(1) ALL PERFORMANCE REPORTS SHOWN, GIVEN OR SENT
TO CUSTOMERS BY MEMBER FIRMS BE INITIALLED
BY THE FIRM'S LOCAL OFFICE SUPERVISOR TO INDICATE
A DETERMINATION BY THAT SUPERVISOR THAT THE
PERFORMANCE REPORT FAIRLY PRESENTS THE STATUS
OF THE ACCOUNT OR THE TRANSACTIONS REPORTED
UPON;

(2) COPIES OF ALL SUCH PERFORMANCE REPORTS SHOWN,
GIVEN OR SENT TO CUSTOMERS BE RETAINED BY
MEMBER FIRMS IN A SEPARATE FILE AT THE LOCAL
SALES OFFICE;

(3) REGISTERED REPRESENTATIVES BE PROHIBITED
FROM SHOWING ANY PERFORMANCE REPORT OF THE
OPTIONS ACCOUNT OF ONE CUSTOMER TO OTHER
EXISTING OR POrENTIAL CUSTOMERS, UNLESS
COMPOSITE FIGURES WHICH FAIRLY PRESENT
THE PERFORMANCE OF ALL THAT REGISTERED
REPRESENTATIVE'S CUSTOMER OPTIONS ACCOUNTS
DURING THE SAME PERIOD ARE ALSO SHOWN.

425

G. PROMOTING OPTIONS - INVESTMENT PROGRAMS

1 . Introduction

A common promotional device used to sell listed options is the
"options program," an investment plan employing the systematic
use of an ootions strategy. Programs generally involve a repeating
cycle of investments, made for the participating customer by a
reqistered representative pursuant to either a formal or informal
grant of discretion from the customer .

Options programs are generally of two types: (1) those sponsored
and manaaed centrallv by a brokerage firm or its investment advisory
affiliate; and (2) those promoted and managed locally by registered
representatives or their affiliated advisers. There are many
variations of these two program types.

More than 27 percent of the brokerage firms in the industry
group sample offer to their customers "managed options accounts" ,
usually under the central control of an investment manager chosen
by the firm. Almost all firms offering such services require that
participating customers have substantial net worth and income —
and, in some cases, a great deal of sophistication in financial
matters. These programs usually employ only covered call writing
strategies which are sometimes further limited to the writing of
options only against stock which was in the participant's portfolio
before he entered the program.

426

One brokerage firm's description of its centrally managed options

proqram reflects the generally conservative approach of firms toward

such programs:

Managed option accounts are offered to customers on a
highly selective, individualized basis. ... [T]r ad ing decisions
are made by senior officers of the firm who have long and
successful option management histories. This service is
only offered to customers who have both the sophistication
necessary to evaluate the risks involved and the financial
means to absorb loss.

In contrast to the conservative approach and high standards
which many firms attempt to maintain for their centrally managed options
proqrams, the same firms often have poor or inadequately enforced
standards concerning "programs" run by local options "experts".

2. The Attraction of Options Investment Programs

To customers who find options complex and confusing, or who have
insufficient time to follow their investments, an options program may
apoear to be an attractive way to participate in options trading.
By joining a program, the participant avoids the frequent and often
difficult investment decisions which are necessary in options trading,
and instead relies on the judgment of an industry professional
who is often touted as an "expert" in options.

To the registered representative and his brokerage firm, options
programs offer an obvious attractive opportunity to earn
substantial , steady commissions from the repeating investment cycles
which characterize such programs. The commission generating oppor-
tunities in just one cycle of a simple covered writing program are
deoicted in Figure I:

427

FIGURE I

COVERED CALL WRITING

VARIATION ONE - SIX COMMISSIONS

Step I

Sell

securities
presently
in account

Step 2

(calls exercised;
Step 3

Step 4

Purchase Write CUSTOMER Deliver

OPtionable calls v. ASSIGNED stock

securities securities EXERCISE

Step 5

Replace
stock ;
write more
calls

(sc

(sc)

(ocr

(sc)

(sc) (oc)

VARIATION TWO - FIVE COMMISSIONS

(calls repurchased before expiration]

Step 1

Sell

securities
presently
in account
(sc)

Step 2

Rjrchase

OPtionable

securities

(sc)

Step 3

Write
calls v.
securities

(oc)

Step 4

Repurchase
calls

(oc)

Step 5

Write more
calls

(oc)

VARIATION THREE - FOUR COMMISSIONS

(calls permitted to expire)

Step 1

Step 2

Step 3

Step 4

Step 5

Sell

securities
presently
in account

FUrchase

ootionable

securities

Write
calls v.
securities

Calls expire

without

exercise

Write more
calls

sc)

(sc)

(oc)

(no commission) (oc)

* "sc" = stock commissions
** "oc" = options commissions

428

In any of these variations, the cycle is repeated for the investor

who continues to participate in the program. At each step (except as

noted), there is at least one commission charge.

To convince their salespersons to sell listed options, some brokerage

firms emphasize how options investment programs can generate substantial

commissions. At the behest of his firm, one registered representative

told his peers:

My goal this year (my #1 year in production)
is $150,000. I feel I have a fair start at $75,000
for the first five months. Options have accounted
for approximately 50%. Without the concept of
a packaged program, I doubt if these figures
would be here this soon . . .

3. The Selling of Options Investment Programs
a. Sales presentations

The revenue producing qualities of managed options programs cause
firms to market such proqrams heavily. The promotional materials usually
stress the use of computers, "mathematical models", statistical analysis,
economic models, and other features which highlight the sophistication
of the program. The Options Study has found that these "highlights"
are sometimes merely a selling device.

Another benefit of managed options programs stressed in pro-
motional materials is the commitment of the registered representative
or the firm to monitor closely the customer's account in order to
avoid losses. As one registered representative put it:

"I stand ready to assume the total responsibility
of monitoring the option positions on a daily basis
so that your necessary involvement need be no more
time consuming than depositing the checks as
they come in ."

429

Manv ootions customers have relied heavily on their registered
representatives to monitor their accounts. Unfortunately, this reliance
is sometimes misplaced. Particularly where small investors are concerned,
reqistered representatives may find monitoring customer options accounts
a nuisance. One national firm, that regularly advertises its willingness
to handle small customer accounts, related to its sales force how a
successful salesman ("Rick") dealt with this problem — simply by recom-
mend inq far-term options series to small customers:

With insignificant option writing accounts
($10,000-$15,000) [Rick] suggests that he
writes options as far out as possible and
therefore has the customer participating,
but not necessitating customer review and
personal contact. This allows [Rick] to
continuously monitor his major accounts and
constantly uporade his clientele through
aggressive prospecting. There is no diffi-
culty understanding [Rick's] success.

A salesperson's failure to monitor options accounts can cause
customers to experience substantial losses, as the following case
illustrates:

A retired couple who previously had owned only municipal bonds
and "blue chip" securities was persuaded to entrust $100,000, more
than half of their net worth to a registered representative's uncovered
call writing program. The couple claim that they were told that such
a program was "conservative" and "absolutely safe". When the couple
asked about oversight of their account, they were assured by the
registered representative that he "would handle their account as if
it belonged to his parents."

430

After six months of options trading, the registered representative
called the retired couple and informed them that their account had lost
between $6,000 and $8,000 and that he was leaving the firm's employ.
The couple then requested that their account be closed and their capital
returned to them. Tney were advised, however, that margin requirements and
"pending commitments" of the program made withdrawal of equity unwise.
Instead, their registered representative proposed to turn their account
over to one of his colleagues who would undertake to close the account.

During the next several months, the couple complained several
times about the firm's lack of progress in closing the options account.
Each time they were told that more time was needed to unwind the
proqram. In fact, the firm's failure to monitor this account permitted
losses to accumulate in excess of $90,000.

The couple later explained how they came to repose such confidence

in their reqistered representative:

At the beginning [our registered representative]
did occasionally keep us generally advised as to
his investment direction but he felt that since we
were not completely acquainted with options pro-
ceedings we should trust his and [the brokerage
firm's] judgment since that is what they were
being paid to provide.

b. Prepared sales presentations

Some options programs are sold by means of sales presentations

prepared by the brokerage firm for registered representatives who

themselves may not fully understand the program. Tnese prepackaged

sales presentations for options programs are sometimes popularized

by area "options co-ordinators" who may maintain a network of

"ootions product leaders" throughout the branch offices of a firm.

431

In one national brokeraqe firm, a regional options coordinator prepared
the following script for his firm's representatives to use in selling
listed options:

(1) With an "established customer":

— "George, you have had a bad five years. Things have not
worked out the way we have planned. You have had the
risk inherent in the ownership of your stocks during all
those years. If you are still willing to accept that risk
and if vou are willing to accept a 15-20% annual return
on your investments, I would like to discuss a program
with you. What I am asking is would you be willing
to double your money every four years?"

(2) The "portfolio approach"

"You have a $100,000 portfolio. Do you know that I can
rent that out for $80/day, $560/week? Are you making that
kind of return on your money now? [Customer]: 'I want
to talk to my accountant, my wife, etc.' [You]: 'How
long will that take?1 [Customer]: 'Oh, about a month.'
[You]: 'If you had an apartment building worth $100,000
would you leave it unoccupied for a month? I can get
you $2,400 in the next 30 days by renting your portfolio,
let me know."

"Work up two portfolios.... [The] [f]irst
should be a conservative one - BS, T, HR,
RCA, etc. This one will sell the program to
the customer. Should title it 'Suggested Port-
folio'.... Set up a second, more aggressive
portfolio. Let customer see it but do not
emphasize it. You try to sell him the conserva-
tive one. Chances are he will opt for the aggres-
sive one."

432

— "Be sure you have portfolios written up before you
make your call. If you say, "I'll call you tomorrow
with some ideas", you have lost your impact. Fort-
folio should consist of 10 stocks. If he doesn't
like two, eliminate them. You have just sold eight
stocks."

(3) "Converting" a customer into an options writer;

— "When you have him sign the papers, be certain you
get the first order with them. Cnce he has signed
the papers and given you the order, he is psycho-
logically ready. You have helped unburden him
making an immediate $100,000 decision and he is
thankful for that."

— "Cnce the RCA is done, call him and tell him you will
mail him a check tomorrow for the option premium.

It will probably be the first profit he has seen in
five vears. It will improve his disposition immeasur-
ably."

— "...lb earn 15-20% you must create the entire portfolio
This is the standard pitch if the customer does not
choose to complete the portfolio. You must let him
know that he has assumed the responsibility for any
underperformance in the program."

SalesDersons are then admonished that, after the customer signs the
ootions papers, they should "get commitments for [regular] referral [s]
and [future] addition[s] of capital ."
c. Team tactics
Programs run out of local sales offices are frequently formulated
and promoted by sales management "teams". These teams may consist
solely of registered representatives employed by the firm or may
include an investment advisor from outside the brokerage firm. Typically,
one or more members of the team are the business getters — soliciting

433

customers. The other acts as the "money manager" or "options specialist"

who will meet the customer, if at all, only during the closing sales

presentation when the entire team seeks to impress the customer with

its exDertise or the sophistication of its "system".

Customers sometimes complain about the high pressure sales tactics

employed by seme of the teams selling listed options, and, indeed, the

Cotions Study has seen a number of cases in which sales^nanagement

teams were enqaqed in selling practice abuses. Nonetheless, industry

literature and internal documents of brokerage firms, encourage the

establishment of sales teams to prospect for new business, particularly

options business. For example, one regional options coordinator reported

to his network of registered representatives in his monthly newsletter:

Which offices are growing the fastest in options
and how are they doing it? [Branch A] has organized and
formed more teams than the NFL. These groups are selling
programs and are starting to build large equity pools.
They are concentrating on selling and not on out-smarting
the market or overmanaging the equity they have. Watch
them over the next few months. (Emphasis in original.)

Cf the firms in the industry qroup sample, 84 percent allow registered

representatives to split options commissions, normally an indication

that sales-management teams are welcome within the firm.

d. Particular options investment programs

(1) The covered call writing program.

Covered call writing programs appear to be the most popular of

all options programs.

Sales presentations for covered writing programs frequently emphasize

the "income" producing aspects of covered writing. One salesman testified

434

about the way in which he sold these programs:

...I tried to get the customer to think in
terms of checks coming to his house; the
dividend checks would come in, the option
premium would come in, get him thinking in
terms of receiving five checks a year, six
checks a year, rather than four. Painting a
mental picture of that.

Sales presentations for covered writing programs also emphasize their

"conservative" nature. An excerpt from a mailer sent to a random selection

of potential customers by a registered representative in a major brokerage

firm is tvpical of the "conservative" approach:

Che of the fastest qrowing segments of the
securities business consists of the conser-
vative investment strategy of writing options
on common stock. Using this technique, you
can expect to substantially increase the current
yield on existing or purchased stock positions
while at the same time reducing your market risk.

Still other sales presentations focus on the "risk-reduction"

features of call writing programs. Cne prepared sales presentation

reviewed by the Options Study has the registered representative telling

the potential investor :

We no longer care whether the market is up 10,
up 50, down 50. We have transferred this risk
of ownership to the option buyer .

What most sales presentations do not stress is the risk of

covered writing programs — or covered writing in general. The

principal risk is that the underlying stock will decline in value

far more than the amount received by the program participant in

435

premiums on the options he writes. The risk is especially great if the
stocks nurchased under the programs are volatile.

For example, a customer during 1977 was persuaded by his
reqistered representative to switch his tax free and fixed income
securities into a covered writing program. The registered representative
had emphasized that such a program was "conservative" but did not
exdain that the stocks purchased in the program were less "conservative"
than the securities already held by the customer. Moreover, the customer
misunderstood the meaning of "conservative." He understood a "con-
servative" program to be one which had income and capital preservation
features similar to his previous fixed income securities investment
olan. The customer was therefore completely unprepared for the losses
which resulted from a decline in the price of the stocks into which
he had been switched. In only a few months this investor suffered
losses on his newly assumed stock positions in excess of $7,500, almost
twice the options premium "cushion" he had received from writing calls
on the stocks.

When the investor complained to the brokerage firm, the firm
resoonded that owninq a stock and writing calls against it was
more "conservative" than merely owning that same stock. Tne firm never
dealt with the investor's complaint that he would never have purchased
such volatile stocks if he had been made aware that the risk of loss
was so large.

436

Although qreater risks of loss on the underlying stock are associated
with writing covered calls on margin, because of the larger positions
taken through borrowing, these additional risks are often not explained
to customers. The lack of attention to the risks of trading options
on margin is all the more surprising in light of the fact that brokerage
firms actively encourage salesmen to open margin accounts for options
customers by emphasizing the larger commissions available from margin
accounts. In addition, some options strategies can be pursued only in
a margin account.

An example of the risks of trading options on margin is found in
one discretionary account analyzed by the Options Study.

On June 1, 1977, the investor's account held a large position in
one "blue chip" eouity security with an aggregate market value of
$855,000. Qi that date, the investor was convinced by her registered
representative to deposit this stock in a newly opened margin account
in which covered options were to be written. The borrowing power
created was used to finance the purchase of several more volatile
stocks against which listed call options were written.

By June 1, 1978 the same investor had experienced the following
gains and (losses):

loss on Stocks - realized (132,500)

Loss on Stocks - unrealized (177,900)

Gain on Expired Options 35,700

Dividend Income 10,600

Interest Expense ( 44,400)

Net Loss (308,500)

437

These losses represented 36 percent of the investor's initial account
eauity. Had the investor refrained from margined call writing against
volatile stocks and merely held her "blue chip" position, her account
would have decreased by $156,000 or 18 percent. Again, this account
received a sales pitch which emphasized the conservative features of
a covered call writing program, but was not apprised of the special
risks attendant to investing in options on margin.
(2) Exotic and advanced options programs

Some registered representatives and firms offer managed options
oroqrams which employ complex trading strategies that even very
sophisticated investors cannot always understand. Frequently, the
risks of these programs are misrepresented to customers. For example,
an uncovered call writing program is generally acknowledged to
be a highly risky undertaking. However, the Options Study encountered
situations where salespersons claimed that such programs had "capital
preservation" features or were "not speculative". Variations of un-
covered writing programs (e.g. , ratio writing and partly covered
warrant-option hedges) have also been sold to investors as though
they were simdy another form of "conservative" covered writing
program.

In addition, the complexities of advanced programs can serve to conceal
Questionable trading activities by registered representatives and, thus,
bear special risks for investors. For example, one middle-aged widow
entrusted common stock of twelve blue chip equity issues to her registered

438

representative's "aqqressive" discretionary trading program. The registered
representative immediately liquidated the investor's portfolio (generating
$1,600 in stock commissions) and used the proceeds of $113,000 to establish
the following positions for the investor's accounts:

7 opening uncovered call sales

17 spreads (both vertical spreads and time spreads)
15 ODening call purchases

4 short sales of stock hedged with call purchases (synthetic puts)

Althouqh the investor was told that her accounts were well hedged
and diversified as a resuit of this trading, the hedges dissolved
and the initial diversification of the account disappeared within
weeks. First, the investor's accounts were assigned fourteen exercise
notices, forcing her to buy stock to cover uncovered short call positions
and, at the same time, eliminating one side of some spread positions.
As a result, the investor's accounts realized trading losses, additional
commission costs, and incurred a disproportionate increase in risk.
During the same period, some of the account's long call positions
which were part of time spreads expired worthless, eliminating
one side of several spreads ("leglifting" ) and leaving the account
subject to the greater risks of now uncovered short call options
positions. (Time spreads with a short position having a more distant
maturity than the long position, are generally considered to be more
risky than those in which the long position has a more distant
maturity.)

439

After four months of options trading, when the customer withdrew
discretionary authority over the account, her account had suffered
losses of approximately $50,000, more than half of which were paid
to the firm as commissions and margin interest,
e. Conclusions

Options investment programs aggravate the regulatory problems
involved in options selling. The Options Study believes that recom-
mendations put foward elsewhere in this chapter of the report will
remedy many of these problems. Of particular importance are the
recommendations concerning discretionary options accounts, systematic
reviews of account activity and control of performance reports.

440

H. OPTIONS TRADING IN CUSTOMER ACCOUNTS

1. Introduction

The combination of an option's short life and the complexity of
options trading in general has made it apparent to many customers that
they have neither sufficient time nor understanding to monitor with
adequate diligence the trading activity in their own accounts. As a
conseauence, many customers rely heavily on their registered representatives
for options trading decisions. This reliance, in many cases, is so great
that registered representatives can effectively control all trading
in these customers' options accounts. Since this control is not always
exercised wisely or fairly, problems can arise.

One major problem for the customer is unsatisfactory performance by
his registered representative. This less than satisfactory performance
may result from the salesman's simple lack of knowledge about options
tradinq, or from the temptation to abuse the customer's account arising
from the commission potential of options trading. In some cases,
customer losses are the result of both the lack of knowledge and also the
self-interested conduct of registered representatives.

Abuses, such as excessive and unauthorized trading, often go
unchecked until substantial losses are sustained by the customer . Tne
delay in detecting such problems occurs because supervisory systems are
inadequate, or because the customer is so confused by his account statements

441

- or misled by inaccurate performance reports - that he cannot determine
the result of trading in his account. These and other problems that seem
to arise often in the accounts of options customers are discussed below.

2. Excessive Trading

As noted earlier in this chapter, the industry's usual commission
structure for options makes them an attractive sales product for
commission-dependent salesmen. A desire to increase their earnings can
tempt registered representatives to effect excessive options trades
in customer accounts with the primary purpose of generating commissions,
a. Examples of excessive trading

The temptation for a registered representative to trade an options
customer's account excessively is illustrated by the following case
concerning a widow for whom some form of options trading may have been
suitable. When the customer's husband died, he left her more
than $400,000 in securities. Since the widow had never participated
in the family's financial affairs, she readily entrusted her entire
securities portfolio to a local representative of the firm with which
her husband had dealt. Starting in 1970, and for several years, that
registered representative primarily traded equities in her account,
following the pattern that had been established in her husband's account;
an average of 40 trades per year were effected and annual commissions
averaged approximately $7,300.

442

In 1974, however, (the year following commencement of listed options
tradinq) the registered representative began trading listed options
in her account. In that single year, he effected more than 200 trades
and qenerated nearly $40,000 in commissions, more than 25 percent of
his total gross commissions for the year. While the loss of $200,000
in the account cannot be attributed solely to options trading, options
transactions contributed significantly to these losses and provided
the vehicle by vhich this salesman earned extraordinary commissions
at the expense of this unknowing client. The following table summarizes
the activity in this account:

TABLE II

Commissions as

percentage of

Year

Number of Trades

Commissions

account equity

1969

1970

4,519

0.9%

1971

3,533

0.7

1972

13,567

2.8

1973

6,745

1.4

1974*

243

39,693

10.7

1975 (5 months)

20,020

6.9 (5 months)

* beqan tradinq options

Many other situations involvinq apparently excessive tradinq
of options accounts have come to the attention of the Options Study. 38/

38/ These cases come from several sources, including: the review of
customer complaints submitted by broker/dealers or received
directly from customers; Commission enforcement actions; private
litigation; the disciplinary proceedings of self -regulatory organi-
zations; and the reports of broker-dealer inspections by self -regulatory
organizations and the Commission's staff.

443

From these cases the Options Study has identified certain factual
natter ns which seem to be commonly associated with excessive trading
problems .

( 1) The obvious churning case
Excessive trading of a customer's account is often accompanied by
other fraudulent conduct. For example, the Options Study reviewed one
case where a national brokerage firm and several of its employees
apparently were engaged in concurrent excessive trading, misrepre-
sentation, suitability and supervisory violations. Two registered
representatives using a variety of misrepresentations, induced fourteen
customers to open discretionary accounts; each was to be managed in
accordance with the registered representatives' options trading program.
These fourteen customers invested a total of $372,550, suffered losses
of $117,122, and were charged commissions of $98,588. Although the
average account was open only 12 months, average commission costs
exceeded 25 percent of the money invested. Tne table below summarizes
the results of the trading in these accounts:

444

TABLE

III

Commissions as

Losses

Total

A Percentage

After

Percentage of

Customer

Investment

Commissions

Of Investment

Commissions

Investment Lost

$ 77,566

$18,401

23.72%

$ 22,494

29.00%

144,092

18,177

12.61%

9,191

6.38%

5,405

3,820

70.68%

5,391

99.74%

14,867

1,212

8.15%

5,303

35.67%

28,425

15,706

55.25%

24,753

87.98%

16,122

9,993

61.98%

14,487

89.86%

3,943

1,655

41.97%

2,228

56.51%

9,732

4,018

41.29%

3,634

37.35%

10,844

445

4.01%

927

8.92%

18,220

7,377

40.49%

5,365

29.45%

8,558

4,472

52.27%

4,824

56.37%

18,177

3,605

19.83%

8,982

49.42%

11,730

4,085

34.83%

5,609

47.82%

4,869

5,622

115.47%

3,894

79.98%

Total

$372,550

$98,588

26.26%

$117,122

31.44%

Account "G" belonged to a young serviceman and his wife. This
family's total income was $23,000, and their net worth approximately
$20,000. Neither the serviceman nor his wife had any prior investment
experience in the securities markets. In late 1976, they approached
this national brokerage firm to determine if they could find an investment
offering a return higher than they were receiving on their $4,000 bank
savings account.

The two registered representatives recommended to the couple a "low risk"
options program - one which they represented offered returns on investment of
up to 35 percent. Enticed by this sales presentation, the couple deposited their

445

entire $4,000 of savings in a discretionary account with the brokerage firm.
During one year, the two registered representatives generated commissions of
about $1,600 (40 oercent of the equity invested), and lost more than $2,000
of the couple's original investment.

As part of the trading in this account, a series of discretionary
transactions were effected which had little or no investment merit.
For example, one of the registered representatives purchased 300 shares
of common stock and wrote three in-the-money calls against that stock.
The maximum gain to the couple from the trade, after deducting commissions,
would have been $199 if their options had been exercised and the stock called.
The couple Dlaced at risk $2,719 (the cost of the stock less the premium
received) while the commissions to the brokerage firm, which would be generated
if the stock were called, would have been $203. Several other trades in
the couple's account appeared to be worthwhile only for the registered
representatives and their firm or, at best, were only marginally profitable
for the customers.

(2) The retired school teacher

Excessive trading is often associated with inexperienced, unsophis-
ticated customers. A classic example is the experience of a retired
school teacher who had onlv limited experience in the stock market
and who had never invested in options. Her primary source of income, the
dividends from her portfolio of "blue chip" securities, was barely sufficient
to meet her needs. When a registered representative from a national brokerage

40-940 O - 79 - 31

446

firm advised her that returns of 40-50 percent were possible from
a program he had devised for trading listed options, she thought
she had found the answer to her income problem. Indeed, she was
so anxious to participate in his program that she permitted
the registered representative to misrepresent her net worth on the
options account information form. Such falsification was necessary
to secure aporoval of her discretionary options account since her
actual net worth did not meet the brokerage firm's minimum standard
for the salesman's "aggressive options trading" program.

When the customer's discretionary account was opened, in April
1977, account equity totalled $115,000. At that time, she signed a
statement indicating her goal of 35-40 percent appreciation and
acknowledging that achievement of this goal "may result in frequent
trades and substantial commissions." Despite this statement, she
did not appreciate the risk she had assumed, did not understand the
trading strategies employed, and could not comprehend her account
statement .

When trading was halted, after four months, the equity in the account
had declined to $64,000, a loss of $51,000. During this period, the
reqistered representative generated more than $25,000 in commissions,
an amount equalling more than 20 percent of the invested equity in the
account.

447

( 3 ) The wealthy executive

Excessive trading problems are not only associated with unsophisticated
customers, or customers of limited resources. Another type of excessive
trading case involves the customer who possesses a basic understanding
of options and is financially able to bear the risk of substantial losses,
but who does not have time to make the necessary trading decisions and,
accordingly, gives his registered representative discretionary authority
to manage his options account. One such investor, a wealthy real estate
executive, entrusted more than $500,000 to a registered representative
employed by a regional brokerage firm. In less than two years, the
account lost nearly 70 percent of the money invested; more than $80,000
of the loss - - 24 percent of the customer's average investment during

the period was collected by the brokerage firm as commissions.

Not only was the trading extraordinarily heavy in this account, but
the risks taken were also excessive even for a customer with financial
resources .

b. What is excessive trading?

The cases above illustrate instances of "excessive trading",
that is, trading in a customer's account which bears little relationship
to the customer's needs or objectives.

The ant i fraud provisions of the Federal securities laws have been
held to prohibit excessive trading, or "churning", by a broker-dealer
in a customer's account since such conduct violates the broker-dealer's
obligation to deal fairly with the public in compliance with the accepted
standards and practices of the profession. 39/ In Exchange Act Rule 15cl-7,

39/ Hecht v. Harris, Upham & Co. , 430 F.2d 1202, 1207 (9th Cir. 1970).

448

an antifraud rule applicable to over-the-counter securities markets,

the Commission defined churninq as follows :

[A]ny act of any broker [or] dealer .. .designed to effect
with or for any customer's account in respect to which
such broker [or] dealer... or his agent or employee is
vested with any discretionary power any transactions or
purchase or sale which are excessive in size or
frequency in view of the financial resources and
character of such account. 40/

Bv analogv many of the concepts of Rule 15cl-7 have been applied to
trading in other securities through the Commission's general antifraud
provision, Exchange Act Rule 10b-5. 41/

Proof of excessive trading involves several elements. The first element
of excessive trading is control by the registered representative over
the customer's account. Under Rule 15cl-7, control clearly exists where
the customer has expressly granted to a registered representative the
discretionarv authority to effect trades for his account. In addition,
control can exist even though no formal grant of discretion has been made
where the registered representative in fact exercises discretion over
the account. Therefore, trading which is either unknown to or unauthorized
by the customer is "controlled" by the registered representative. Control
can also be inferred if the registered representative significantly
influences the size and frequency of transactions in an account by

40/ Exchange Act Rule 15cl-7(a), 17 C.F.R. 240.15cl-7(a) .
41/ Exchange Act Rule 10b-5, 17 C.F.R. 240.10b-5.

449

reason of the trust and confidence placed in him by the customer. 42/
Such control has been found freouently in cases involving active trading
in eouity accounts where the customer was naive, unsophisticated, or
inexperienced in the workings of the securities markets. In other cases,
the accounts even of experienced investors who have consistently accepted
all recommendations from their registered representatives have been found
to be controlled by the registered representatives. 43/

The second element of excessive trading is a determination that
the transactions effected by the broker-dealer are excessive in size
or frequency in liqht of the nature and resources of the account and
the investment objectives of the customer . 44/

Since excessive tradinq "cannot be and need not be, established by
anv one orecise rule or formula," 45/ several factors are relevant

42/ See generally WOLFSON, supra note 15 at 1| 2.11.

43/ Russell L. Irish, 42 S.E.C. 735, 736-737 (1965), aff'd sub nom.
Irish v. SEC, 367 F.2d 637 (9th Cir . 1966), cert ."denied, 366
U.S. 911 (1967).

44/ In this regard, the prohibition against excessive trading is related
to the suitability doctrine in that churning is, by definition,
unsuitable for any customer. Both principles are designed to protect
customers bv obligating broker-dealers to act with customers' interests
uppermost in mind. The principal distinction between the two concepts,
however, is that churning applies to a series of transactions while
suitability also applies to each individual trade as well as a series
of transactions.

45/ Hecht v. Harris, Upham & Co., 283 F. Supp. 417, 435 (N.D. Cal . 1966),
aff'd, 430 F.2d 1202 (9th Cir. 1970).

450

in determininq whether an account has been traded excessively. The
nature of the account must be considered since the trading in an account
need not only be active but must also be inconsistent with the financial
circumstances and investment objectives of the customer. Fbr example,
a moderate level of activity might constitute excessive trading where the
investment objective of the customer is capital conservation, while the
same or hiqher level of trading might not be considered excessive in the
account of a customer seeking short term profits. In addition, whether
active tradinq in speculative securities is appropriate in a particular
account deDends, in part, on whether the customer is financially able
to bear the assumed risk of loss.

Since the motive behind excessive trading is usually the registered
representative's interest in generating commissions, evidence of trading
which is designed "to derive profits for [the broker-dealer or salesperson] ,
while disregarding the interest of the customer", 46/ while not necessarily
an element of the offense, is another factor to be considered. Fbr example,
the repeated purchase and sale of the same security absent any price change,
or the continous switchinq from one security to another with no apparent
rationale, mav reflect the broker's interest in generating commissions.
Options transactions in which the maximum potential profit is entirely
offset by the commissions charged raise similar questions as to the registered
representative's motives.

46/ Ibid.

451

c. The measurement problem

Tne most difficult problem relating to excessive trading is how to measure

activity. One factor frequently used to measure activity is the "turnover

rate" of an account. Various formulas have been used by the Commission

and the courts to measure the rate of turnover. These formulas typically

relate the total cost of purchases made for the account during a period

of time to the average amount invested in the account over the same period

of time. The fiqure derived is the turnover rate. Thus:

total cost of purchases for time period = turnover rate for time period
averaqe amount invested in account for
time oeriod

The formula above is known as the "Looper formula" 47/ and was

desinned for eouity trading. As used in this formula, purchases include

the full cost of all securities purchased whether on a cash or margin

basis during the oeriod to be measured. The amount of average monthly

investment is then calculated by totaling all cash additions to the

account, including cash deposits, oroceeds from the sale of securities,

and dividends; by deducting cash withdrawals; and by dividing the result-

inq total by the number of months in the period under consideration.

The Looper. formula accurately reflects the level of activity in an

an account only if the account is initiated with a cash deposit, if no

other securities are available for liquidation, and if no dramatic changes

occur in the prices of the securities held. If substantial securities

47/ LooDer & Co., 38 SEC 294 (1958).

452

positions are held in the account (or are otherwise within the discretion
of the reqistered representative) , the Looper formula substantially over-
states the degree of activity since the value of these positions is excluded
from the amount of averaqe monthly investment. For example, if $1,000,000
of stock is held in the account and a sale is made releasing $10,000 which
is then reinvested in the same month, the looper formula will yield a
turnover rate of Is

$10,000 (purchases) = 1

$10,000 (averaqe monthly investment)

Obviously, the use of such a turnover rate could be misleading if the

user believes that this rate measures the activity in the whole account.

Similarly, if the values of portfolio securities change significantly,

the formula will not accurately reflect the ratio of the amount of purchases

to the amount of total capital available for investment. This limitation

is particularly significant when an account includes highly leveraged options

positions which are subject to substantial price fluctuation.

A commonly suqaested modification of the Looper Formula is the in-
clusion in "net monthly investment" of all securities available for investment
at market value, calculated monthly. This procedure measures the rate of
turnover of capital available for investment during each month. Applying
this modification to the example above, the sale and purchase of $10,000
worth of stock in an account with an equity of $1,000,000 provides a
turnover rate of .01 per month, a more realistic indication of the activity
within the whole account .

453

Still, neither of these conventional formulations adequately measures
the impact of options trading on the activity in customer accounts since
they completely iqnore the effect of the sale of options contracts. An
account in which calls are sold against stock positions would not reflect
any activity unless the positions were closed through purchases.

The Options Studv has analyzed several alternative methods of measuring

activity in accounts which include options. One approach is to focus on

options alone, bv calculating the number of contracts bought or sold in

opening transactions per every $1,000 invested during the period under review.

Fbr example, consider the computations associated with a "conservative"

covered ootion writing account which has $10,000 in equity created by a 400

share long position. At any given time, the 400 share equity position serves

to cover the writing of up to four options contracts. Assume that the account

sells the calls nearest to expiration, repurchases the calls on expiration

date or allows them to expire, and then sells new calls. Using such a

strateav, the account would effect opening transactions for four contracts

once every three months, or for sixteen contracts during a one year period.

The contract activity index would be calculated as follows:

16 (contracts )/12 (months)

$10,000 (account eouity)/$1000 = .13

Table III illustrates the use of the contract index approach by applying

it to several customer options accounts which the Commission, in a

recent enforcement action, found to be excessively traded.

454

TABLE IV

Eouitv *

No. of

Duration

Contract

Account

Invested

Contracts

of Account

Index

$18,236

406

4 months

5.5

31,468

418

4 months

3.3

12,653

370

5 months

5.8

14,214

168

3 months

3.9

23,671

300

2 months

6.4

This method of measurement does provide a convenient basis for
comparinq the activity in various options accounts, but its failure
to reflect activity in other securities in the account is a serious
limitation, oarticularly since many options strategies are not limited
to ootions but also involve the underlying or other securities.

An alternative approach to calculating excessive trading focuses
on the amount of commissions generated by trading in the account rather
than upon the calculation of a rate of turnover. This approach analyzes
commissions earned as a percentage of investment during the period in
auestion. Since commissions ostensibly are the most common motive for
excessive trading, and since commissions provide a basis for comparison
of accounts usinq various investment vehicles, this aoproach offers one
logical solution to the need for a standard formula to measure trading
activity in customer accounts which include options.

* Eouity fiqures used in the calculations in Tables IV and V (below)
represent the customer's total investment in the account. A more
precise calculation would be to divide monthly commissions by account
eouity for that month (or average monthly commissions by average
account eouity) .

455

The use of commissions to measure excessive trading is illustrated
in the following table, using the sane accounts set out in Table III above:

TABLE

Monthly

Eouity *

Duration of

Commission/

Account

Invested

Commissions

Account

Equity

Sia,236

9,234

4 months

.13

31,468

18,975

4 months

.10

12,653

13,242

5 months

.21

14,214

8,215

3 months

.19

23,671

12,303

2 months

.26

In addition, the commission approach appears to be workable since
the accounting information necessary for this calculation is readily
available in the industry. Most brokerage firms currently calculate
commissions generated by each account on a monthly basis. They also
generally oossess the capability of calculating the equity in each
customer account on a monthly basis either within their existing
accounting systems or through the use of other currently available
technoloav. Thus, a simple formula of commissions as a percent
of account eouity on a monthly and year-to-date basis could provide
the needed measurement of activity for brokerage firm supervision of
accounts but would reouire no more information than is otherwise necessary
to maintain adequate surveillance over options accounts. While the use
of this formula cannot, by itself, specifically determine whether an
account has been excessively traded, it does provide a means of corn-
oar ison necessarv to such a determination.

* See note, o. 158.

456

d. Account review procedures to control excessive trading
Illegal excessive trading can occur only in an account over which
the registered representative exercises significant control. As noted
elsewhere, options customers freauently grant registered representatives
such control, either formally or informally. The Commission and the exchanges
have imposed rules which together require: (1) that every discretionary
options account be specifically authorized by the customer in writing;
(2) that every options trade in a discretionary account be initialed by
an ROP; and (3) that every order ticket for a discretionary options trade
be identified as such. 48/ Often, however, a registered representative
exercises discretion over an account without complying with these require-
ments. Such accounts, which lack the required documentation and authority
for discretionary trading, are normally treated by firm supervisors as
non-discretionary accounts.

Brokerage firms employ various controls in an effort to help insure that
trading in accounts is not excessive. One approach taken by several major
broker aqe firms is to prohibit discretionary accounts entirely or to restrict
such accounts to those managed at the home office. Other firms reject
this approach, taking the position that "a prohibition [on discretionary
accounts] merely chases them underground". Most firms, including those

48/ See, e.g., Rule 9.10, CBOE GUIDE (CCH) <| 2310. See also Exchange
Act Rule 17a-3(a)(b), 17 CFR 240.17a-3(a) (6).

457

which do not permit formal discretionary accounts, employ same automated

orocedures to detect and highlight a large number of trades effected

in, or substantial commissions qenerated by, all types of customer accounts,

A few firms have computer programs which isolate accounts with high trading

activity by calculatinq turnover rates using Looper-type formulas on

a monthly basis, while others use some combination of commissions or number

of transactions in an account. Customer accounts identified as overly

active usually are then reviewed to determine whether the activity is

justified or whether the trading is out of character for the account.

When firms identify a non-discretionary account with an unexplained
degree of tradinq activity, either the sales office manager or the firm's
comoliance department will frequently send the customer an "activity
letter" which purports to notify the customer about the unusual nature of
the activity in his account. Some activity letters describe the unusual
tradinq activity that prompted the mailing; others simply send greetings
from the branch manager and invite questions about the customer's account.
In either case, many activity letters appear to have been phrased
to protect the firm from liability rather than to inform the customer
that the manaqement of the firm is concerned about the activity in
the customer's account.

Moreover, most firms do not require that customers acknowledge
receipt of, or respond to, activity letters, and none of the firms in
the industry group sample reported routine procedures for sending a
second activity letter to a customer if the first is not acknowledged.

458

Many firms simply file the unanswered activity letters, to be used later,
if the customer complains, to demonstrate the customer's knowledge of
the activity in his account.

The self-servinq purpose served by activity letters is exemplified
by an internal memorandum sent from a compliance officer of a national
brokeraqe firm to one of his subordinates, with copies sent to a partner
of the firm. The memorandum, which expressed concern about options trading
losses in excess of $20,000 in a discretionary account managed by one
of the firm's registered representatives, contained the following hand-
written notation from the partner to the firm's chief compliance officer:

1) Has [John] analyzed other accounts of [the registered
representative] vhere they may be problems?

2) On accounts where commissions are large and trading
active, have we sent [a] "suicide letter" to [the] customer?
It cuts both ways but I think, on balance, it helps the
firm, vfriat do other firms do?

The chief compliance officer returned the memorandum to the partner with

the followinq notation:

[Bill] doesn't want [analysis of other accounts] done
until we have an actual complaint.

Can't send suicide letters to discretionary accounts.

Another weakness of compliance systems that rely heavily on activity

letters being processed by the branch manager is that many branch managers

themselves handle active accounts. Fbr example, a broker-dealer inspection

conducted by the Commission staff in 1978 disclosed one situation in which

the branch manager was personally responsible for an account that was

459

being excessively traded. The account opening documents reflected
that the customer was a retired man with an annual income of $12,000 and
a net worth of $100,000, who listed speculation as his only investment
obiective. Analvsis of this customer's monthly account statements revealed
that during a six month period in 1977, the account had effected 362 options
transactions, established postions worth $286,182, and had incurred losses
of $42,475, including $21,955 in in commissions. Because the branch manager
controlled both the trading in the account and the activity letter review
process, he did not notify the customer of the high degree of activity
in the account nor did the firm provide any effective supervision of the
account activity.

3. Unauthorized Trades

One of the most frequent complaints by options customers is that
their registered reoresentatives have effected unauthorized trades in
their accounts. Indeed the Commission has investigated many customer
comolaints of unauthorized trading and has found that these canplaints
are often an early warning of serious trading abuses, including excessive
trading. For example, the Options Study reviewed a situation in which
a customer had been out of the country and, therefore, out of contact
with his registered representative for several months. During that
oeriod active options trading nevertheless occurred in his accounts.
After this customer complained of unauthorized trading in his

460

account, an investigation revealed that the registered representative
had effected unauthorized options trades in the accounts of at least four
of his other customers, recommended options transaction not suitable for
other customers and engaged in excessive trading in still another customer's
options account.

Complaints about unauthorized trading in a customer's options
account are sometimes an indication that options trading is unsuitable
for the customer or that he is otherwise confused about the status of
his options account. The customer who does not understand a proposed
strategy or trading program may inadvertently "authorize" a transaction
without ccmorehending its nature or its risks. This confusion can result
in the sale of options investment programs to customers for whom such
orograms are unsuitable.

Too freauently, firms fail to investigate customer complaints of
unauthorized trading thoroughly. The apparent rationale for this failure
is a desire to discourage such complaints since some customers complain
that a trade was unauthorized when, in fact, the trade simply caused them
to lose money. The Qotions Study has found that often a firm's response
to a complaint will be to obtain the registered representative's version
of the episode and then resolve any conflicts in favor of the registered
representative .

461

In one instance, during 1977, a brokerage firm received complaints from
five options customers about a single registered representative. In each
case, the customer accused the registered representative of making mis-
representations, recommending unsuitable trades, doing unauthorized trades
and generally mishandling the customer's account. In addition, several
other customers of that registered representative complained of excessive
tradinq of their accounts. The firm responded that the customers presumably
knew what they were doinq at the time of the trades and, therefore, should
not complain (or blame the firm or its registered representative) because
their ootions transactions turned out badly. By mid-1978, this registered
representative had twice been the subject of self-regulatory disciplinary
oroceedings and had been sued by several customers.

Proper supervision requires that firms investigate customer complaints
of unauthorized trades. The Commission's investigations show that in many
instances, had suoervisors followed up on complaints of unauthorized trades,
they would or should have discovered excessive trading, uneconomic trading
and/or unauthorized trades in the complaining customer's account as well
as in the accounts of other customers handled by the salesperson concerned.

4. Uneconomic Trades

a. The trade with little or no profit potential

The adverse effects of the conflict between the interests of
commission-dependent salespersons and the interests of their customers can
be seen most clearly in instances where the registered representative

40-940 O - 79 - 32

462

recommends a transaction which will give him more in commissions than
his customer can hope to realize in profits. Indeed, the Options Study
has reviewed some trades in which the best possible outcome for the customer
was a loss. Fiqure II depicts one such options trade in which the customer1!
best possible outcome is a two dollar loss, regardless of the stock price
at exercise or exoiration.

463

Date of Transaction:
Strategy:
Position Assumed:

Cost to Establish Position:

Plus Commission

Caoital at Risk:

Best Possible Outcome:
for Customer

FIGURE I

February 6, 1977

Covered Writing

Buy 200 BCC § 27-1/8 §5425 Cost of Stock

Sell 2 BCC Nov 25 Calls e 3 ($ 600) Proceeds from

• 4825 Calls
$4825

+139

$4964

loss of $2

STOCK PRICE AT EXPIRATION OR EXERCISE

Profit

Profit 20

or
Loss

+$ 300

200
100
0
100
200
300
400
500

Loss

25 30

fesult before
Commissions and Dividend

/ Itesult after
Commissions
and Dividend

Maximum Profit
- $2

-$ 1000

Result

fesult

Before

after

Cost to

Stock Price

Proceeds of

Commission

Commissions

Establish

Expiration

Liquidation

and

Positions

Exercise

or Exercise

Dividend

Commission

Dividend

$4825

$10

$2000

$(2825)

$195

$55

($2965)

4825

4000

(825)

222

(992)

4825

4200

(625).

224

(794)

4825

4400

(425)

227

(59?)

4825

4600

(225)

229

(399)

4825

4800

(25)

230

(200)

4625

5000

175

232

(2)

4=25

5000

175

232

(2)

464

As can be seen from Figure II, the customer's maximum profit
on this covered writinq transaction, before commissions and dividends
was $175. However, after commissions are deducted, the best possible
outcome for the customer would be a loss of $2, even when projected dividends
are included. Of course, should the stock decline, the customer's entire
investment of $4964 miqht be lost. At the same time, the lowest possible
commission to the firm from the transaction would be $139, the commission
charqe for puttinq on the position. Should the stock be sold on exercise,
or liouidated at expiration, commission proceeds would increase.

Covered writinq is not the only strateqy which may be uneconomic
for the customer. Ootions spreads involve at least two, and possibly
four, separate oDtions commission charqes, in addition to possibly
two stock commissions. Althouqh these commissions can have a substantial
effect on the profitability of a spreading transaction, registered
representatives sometimes present to customers the profit and loss
ootential of spreading strategies without considering commissions.
Fiqure III deoicts a "calendar" or "time" spread * which, after
commissions, was at best a break-even trade for the customer.

* A calendar spread involves the purchase and sale of options on the
same underlying stock. The options have the same strike price but
have different expiration dates.

465

FIGURE II

Date of Transaction:
Strategy:
Position Assumed:

Cost cf Transaction: '
Plus CairLission
Total Cost

3est Possible Outcone:

January 27, 1975

Time Spread

BuylAHPOCT30e4 1/8 $412.50 Price of Option
Sell 1 AHP APR 30 § 1 7/8 ($187.50) Proceeds of Option Sale
225.00

$225.00

50.00

$275.00

Breakeven

STOCK PRICE AT EXPIRATION

$20

+300
200

100

Result before Commissions

Result after Commissions

Stock Price

Result

at April

Before

After

Exoiration

"ommissions

Comnissions

Commissions

$20

($225)

$ 50

($275)

( 200)

( 260)

+ 75

( 75)

100

( 175)

( 125)

100 •

( 225)

466

On July 20 , 1976 a registered representative for a regional
brokerage firm convinced his customer to effect the following vertical
or money spread:*

Buy 3 PRD Oct 30 <§ 8-5/8 $ 2,587.50

Sell 3 PRD Oct 35 @ 4-1/4 -1,275.00

1,312.56

The best possible outcome for the customer after commission was a $4.52
loss while the customer could have lost as much as $1430.68. Figure IV
below depicts the profit-loss potential of this "underwater trade" both
before and after accounting for commissions.

* A vertical spread involves the purchase and sale of options on the
same underlying stock. The options have the same expiration date
but have different strike prices.

46:

Figure III
Date of Transaction: July 20, 1976

Strategy:
Position Assumed:

Cost of transaction:

Best Possible Outcome:
(after commissions)

Maximum loss (Cost of
transaction plus
□emissions)

Money Spread

Buy 3 PRD Oct 30 § 8-5/8
Sell 3 PRD Oct 35 3 4-1/4

$1,312.50

-$4.52

$1430.68

($2,587.50) Cost of Options
( 1,275.00) Proceeds of Options Sale
1,312.50

STXK PRICE AT EXPIRATION
30 35

$300
200
100

Result Before commissions
f '

Profit

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

Result After Commission

A. Assumes that, prior to exercise,
the calls are liquidated in
closing transactions.

B. Assumes assignment against
short call, purchase and
sale of stock.

Stock Price
at October

Expiration

Result Before
Conr.ission

-1312.50
-1312.50
-1312.50
+187.50
+187.50
+187.50

Result After
Commission
(Assume Liquidation
of Calls)

-1430.68

-4.52

-80.60

-86.58

Result After

Corra.ssi.on
(Assume Short

Call Assignment)

-1430.68

-4.52

-260.10

-285.58

468

b. The use of recommendation lists
Some trades vdiich are uneconomic for customers are derived from the
lists of recommended covered writinq opportunities which many firms dis-
tribute to their salespersons or to customers. Frequently, these recom-
mendation lists show the rate of return on an investment if the call is
exercised, since this assumption will show the best return on investment
possible in a covered writing transaction. In addition, the return figure
qenerallv oresupposes a minimum purchase of at least 300 shares of stock
and the sale of three calls in a customer's margin account. Comparable
returns would not be possible for a smaller trade or for trades effected
in a cash account since the relative commissions would be higher and the
customer's derosit qreater than what they would be in a margin account.
For example, the followinq covered writing recommendations were disseminated
bv a large national firm to its sales staff in May 1976. The firm's
recommendation list included the information in Columns I through IV. Column
V, calculated bv the Ootions Study and based on a purchase of 100 shares
and the writinq of one call, demonstrates the significance that commissions
can have on the small investor and his choice of options strategies.

III

Rate of

return if calls

Ootion

Stock

Option

exercised (300

Series

Price

shares, 3 calls)

CIC Jan 15

14 1/8

13/16

19 %

MOB Nov 60

58 7/8

3 3/4

FCF Oct 15

14 7/8

TR Nov 25

23 7/8

1 5/8

JM Nov 30

29 7/8

2 5/8

EK Jul 110

107 1/8

5 1/8

Rate of

return if

call

exercised

(100

shares, 1

call)

5.7

5.1

7.5

7.2

5.8

469

Oie registered representative testified that he effected for a
customer account an uneconomic trade which he derived from his firm's
national recommendation list. Such a situation is not unlikely since
firms do not always warn users of the lists that the recommended
transactions may be only marginally profitable or even uneconomic at sizes
different from those recommended by the firm.

Another disturbing aspect of some recommendation lists composed by
major brokerage firms is that the recommendations, including those with-
out adeauate warnings, are sometimes made available to registered repre-
sentatives throuah a toll-free telephone number with only an admonition
to emolovees that the telephone number is not to be circulated outside
the firm. Approximately 20 percent of the firms in the industry group
sample use, or have used, an internal phone service to make periodic options
recommendations available to their sales force. Most of these firms have
no effective controls to prevent dissemination of the toll-free numbers
of these ohone services to public investors. As a result, customers
may be able to use the " Dial -An-Opt ion" features directly.

Transactions with little or no profit potential to the customer are
not necessarily effected only by unscrupulous registered representatives.
The Oct ions Study believes that some customers are involved in uneconomic
transactions simbLy because their registered representatives do not understand
the transactions which they are recommending. Table VT below presents
four covered call writing transactions which one registered representative
actually recommended to and executed for his customers:

470

TABLE VI

Security

Braniff

Coastal States
Ballv Mfq.
Inexco

Maximum potential
profit before
commissions

$270
290
217
249

Commissions

$179
202
121
134

Maximum poten-
tial profit after Capital
commissions at risk

$91
88
96

115

$2836
3841
1863
2332

As can be seen, each of these four transactions results in a commission
benefit to the reqistered representative and his brokerage firm which
exceeds the customer's maximum potential profit after commissions. Moreover,
the customer's best outcome (after commissions are deducted) is small,
particularly when comoared to the capital which the customer must place
at risk. These trades are particularly troublesome because they involve
covered writinq, a strategy widely touted as "conservative" by many
reqistered representatives and brokerage firms.

The Options Study noted that those covered writing trades which
proved to be uneconomic to the customer usually involved recommendations
to purchase stock and to write in-the-money calls against it. This
strateqv denies the customer any profit potential from a rise in the
price of the underlying stock, since it effectively limits the potential
profit of the trade to the amount by which the sum of the time premium
and dividends received exceeds the commission charges for the trades.

An example of such a trade was described in a complaint letter
from a customer . This customer , whose investment objective was
capital appreciation, was convinced by a registered representative

471

for a national brokeraqe f irm to buy 200 shares of International Harvester
at 27 3/4 and sell two calls with a strike price of $25 at 3 7/8 each.
The customer's maximum potential profit was $225 (1 1/8 on each of the
two calls written), olus projected dividends, less commissions. Even
if the customer were not assigned an exercise notice prior to the payment
of International Harvester's dividend ($75 on 200 shares), his maximum
profit (including the $75 dividend) would be $78.53 while his brokerage
firm's commission revenue from the same trade would be $221.47. Tne more
likely event, an exercise prior to payment of the dividend, would deprive
the customer of the $75 dividend and result in a maximum profit to the
customer of $3. 53 - a small return when compared to the investment of nearly
$5,000. This transaction is summarized below in Figure V:

FIGURE V

TRANSACTION: Buy 200 Int'l Harvester § 27 3/4

Sell 2 Int'l Harvester APR 25 @ 3 7/8

$5,550 Cost of Stock
( 775) Proceeds from
4,775 Calls

Cost to establish position: $4775.00
Commission: 130.62

Capital at risk: 4905.62

Maximum qain if
calls exercised
before dividend,
commission deducted
( $221 . 47 ) : $3.53

Maximum return
before commission
and dividend: $225

Maximum gain if call
not exercised before
dividend, commission
deducted ($221.47): $78.53

472

5. Conclusions and Recommendations

The Cptions Study has found numerous problems arising from the dual
role of the registered representative as commission salesman and investment
adviser. These problems include not only excessive trading in customer
accounts and uneconomic trades which benefit the salesperson and his firm
more than the customer , but also recommendations for options trading
unsuitable for customers, use of misleading selling documents to induce
customers to trade options and various misrepresentations to customers
about the status of their accounts.

Earlier sections of this chapter set forth recommendations designed
to improve the controls on customer suitability and to prevent the abuses
of the various forms of salesperson/customer communication. Implementation
of these recommendations would help provide the customer with sufficient
information concerning the status of his account, commissions, and other
cherqes, to enable him to monitor the activity in his own account. The
same controls would also help firms and regulators to analyze and control
customer options account activity.

However , additional controls are necessary to insure that the firm
is able adequately to monitor options trading in customer accounts.
Existing compliance systems, which flag accounts by using a single
parameter for commissions and/or number of trades, are not adequate
to meet the needs imposed by options trading. For example, existing
reviews may not identify rapid or large increases in risk in an

473

account or may not detect irregular trading in a small account in
which the activity level fails to exceed an established parameter.

Likewise, a brokerage firm's system that places total reliance on
activity letters to determine whether a customer is aware of the questionable
trading in his account may not alert the firm's supervisors to a problem
account, Unless the customer understands the purpose of the letter, he
may not give it appropriate attention or the salesperson may discourage
him from returning it or otherwise responding to the firm. In addition,
brokerage firms are hesitant to send candid letters to customers since
the questioned trading may be acceptable to the customer.

As long as firms rely on selection criteria which do not
relate the level of account activity to the equity in the account
or to the customer's investment objectives, they will be unable to
oroperly monitor the trading in customer accounts.

Accordinglv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
ADOPT RULES REQUIRING THAT THE HEADQUARTERS
OFFICE OF EACH BROKER-DEALER ACCEPTING
OPTIONS TRANSACTIONS BY CUSTOMERS BE IN
A POSITION TO REVIEW EACH CUSTOMER'S OPTIONS
ACCOUNT ON A TIMELY BASIS TO DETERMINE:

— COMMISSIONS AS A PERCENTAGE OF THE ACCOUNT EQUITY;

— REALIZED AND UNREALIZED LOSSES IN THE ACCOUNT
AS A PERCENTAGE OF THE CUSTOMER'S EQUITY;

— UNUSUAL CREDIT EXTENSIONS;

— UNUSUAL RISKS OR UNUSUAL TRADING PATTERNS
IN A CUSTOMER'S ACCOUNT.

474

The Options Study found that some of the most serious trading
irreqularities occurred in customer accounts which were handled by a
reqistered representative on a discretionary basis. Since many
of these customers did not understand the risks involved in options
trading, they could not adequately monitor their own accounts. Particularly
vulnerable were customers who entrusted funds to registered representatives
to be manaqed on a discretionary basis according to the terms of options
"programs" which entailed speculative or risky options strategies.
Even the additional customer disclosure information recommended earlier
in this report might not provide sufficient protection for some of these
customers.

Customers who grant discretion over their accounts to a registered
representative depend on that registered representative to make investment
decisions suitable to their investment objectives. Both the Commission
and the courts have held that whenever a customer is dependent upon his
broker, the broker has a special duty not to take advantage of his customer.
49/ This duty has been viewed alternatively as a fiduciary duty 50/ and
as part of the broker's implied representation that he will deal fairly
with his customer. 51/ A violation of this special duty is a violation
of the antifraud provisions of the securities laws.

49/ Pucker & Pucker, 6 SEC 386 (1939); Charles Hughes & Co. v. SEC,
139 F.2d 434 (2d Cir . 1943), cert, denied, 34 U.S. 786 (1944).

50/ G. Alex Hope, 7 SEC 1082, 1083 (1940); Barthe v. Rizzo,
384 F. Supp. 1063 (S.D.N.Y. 1974).

51/ Charles Hughes & Co. v. SEC, supra note 49.

475

In addition, registered representatives who exercise discretion
over securities accounts of customers are subject to the traditional
reouirenents imposed by state law on those who manage the money
of others, including, unless otherwise agreed, a duty to preserve the
beneficiary's capital and to avoid speculation. 52/

The Options Study believes that any registered representative (or
firm) who proposes to exercise discretion over an account trading options
should, as a part of the obligation to deal fairly with the customer,
disclose to the customer the nature and risks of any proposed trading
program or strategy which is not designed specifically to preserve
caoital or which involves speculation. For this disclosure to be
effective, the customer must understand it. Accordingly, the Options
Study believes that, before a customer is allowed to participate in
any discretionary options trading program, the firm and the registered
representative should have reasonable grounds to believe that the
customer is able to bear financially the risks of the proposed trading
trogram and also to understand the nature of the risks involved.

Accordingly, the Options Study recommends:

( 1 ) THE SELF -REGULATORY ORGANIZATIONS SHOULD AMEND
THEIR RULES TO REQUIRE THAT EACH OPTIONS CUSTOMER IN WHOSE
ACCOUNT DISCRETION IS TO BE EXERCISED IS PROVIDED WITH A
DETAILED WRITTEN EXPLANATION OF THE NATURE AND RISKS OF THE
PROGRAM AND STRATEGIES TO BE EMPLOYED IN HIS ACCOUNT; AND

52/ Restatement (Second) of Agency § 425 (1958).

476

(2) THAT THE SROP OF EACH BROKERAGE FIRM PERSONALLY
MAKE A DETERMINATION IN EACH CASE THAT THE DISCRETIONARY
CUSTOMER UNDERSTANDS AND CAN BEAR THE RISKS OF THE OPTIONS
TRADING PROGRAM OR STRATEGIES FOR WHICH IT IS PROPOSED THAT
HE GRANT INVESTMENT DISCRETION TO THE FIRM OR ANY OF ITS
EMPLOYEES; AND THAT THE SROP MAKE AND MAINTAIN A RECORD OF
THE BASIS FOR THAT DETERMINATION.

477

I. EXERCISE PROBLEMS

1. Introduction

Before the availability of listed options, each put and call
options constituted a contract directly between two identifiable
parties, the holder (buyer) and the writer (seller). When the
option holder exercised his option, the contract obligated the
call writer to sell the underlying security to the option holder,
or the put writer to purchase the underlying security from the
option holder .

The introduction of listed options issued by the OCC, however,
has severed the contractual obligations between writer and holder.
In the event of exercise, the holder of a listed option looks to the
OCC, rather than to a specific writer, for delivery or purchase
of the underlying stock; the OCC, in turn, demands performance
from an option writer who is contractually obligated to the OCC
throuqh a broker-dealer firm.

The specific writer to be exercised is selected through an
allocation process. First, the OCC assigns an exercise notice
to a selected broker-dealer firm which has sold, either for its
own account or for a customer account, an option in the same series
as the exercised option. Next, if the assignment is for a customer
account, the brokerage firm re-allocates the exercise notice to
one or more of its public customers according to a plan filed
with and approved by the options exchanges.

40-940 O - 79 - 33

478

When a customer who has written an option is assigned an exercise
notice, he no longer can liquidate his position in the options market
but must fulfill the terms of his obligation. Whether the position was
uncovered or covered, he will incur commission costs.

Although the integrity of this allocation system is vital to the
maintenance of investor confidence in the fairness of the options
markets, the following example indicates that several weaknesses
exist in the present exercise system.

In a series of trades executed in early March 1977, floor
brokers for a national brokerage firm purchased enough Coca Cola
May 70 calls on the American Stock Exchange to close out an existing
ten contract short position in the firm's proprietary account.
By mistake, however, the brokers marked the order tickets as opening
rather than closing purchase transactions. As a result of this
mismarking, the records of the OCC showed that the firm's account
maintained a ten contract long and a ten contract short position in
the Coca Cola May 70' s, while the firm's record showed a flat position
in these options.

On March 2, 1977, Coca Cola declared a dividend of $.77 per share
payable to holders of record on March 16, 1977. In an attempt to capture
this dividend, certain holders of the May 70 Coca Cola call options
exercised their options about two months before expiration. On March 10,
1977, the ex-dividend date, the OCC assigned to the same national brokerage
firm's proprietary account an exercise notice for the 10 Coca Cola May

479

70 call options contracts reflected in the OCC records. Although this
exercise notice was clearly directed to the firm's proprietary account,
the firm's employees "re-allocated" the exercise assignment to the accounts
of several unsuspecting public customers. Had the firm delivered its
own Coca Cola stock to meet this exercise notice, it would have been
forced to forego the $770 dividend on the 1,000 Coca Cola shares
delivered .

Later that day, the brokerage firm employees discovered that
two of the public customer accounts to which they had "misallocated"
these exercise notices had already been transferred to another brokerage
firm. With the cooperation of the new brokerage firm, these employees
were able, in effect, to oass along the exercise assignment notices
to the already transferred customer accounts.

The unsusDecting customers delivered the Coca Cola stock as required,
lost the dividend on that stock, and paid aggregate commissions of $719.50
for the exercise transaction. The brokerage firm, on the other hand,
received a $770 dividend on the 1,000 Coca Cola shares it should have
delivered from its own account in response to the exercise notice.

This misconduct was discovered by one of the exchanges only by
accident and not through any organized examination or investigation
process. 53/ None of the public customers who had been assigned
exercise notices ever learned that he had borne the burden of a

53/ This matter was initially discovered when two exchange employees
overheard a conversation among strangers on the New York subway.

480

misallocation. Despite exchange rules that provide public access
to exercise allocation plans devised by broker-dealer firms, customers
generally have little chance to detect shortcomings in the design or
irregularities in the operation of such plans.

Proper prevention and detection of abuses such as the one described
above require:

(1) an exercise allocation method fair to the public customer; and

(2) adequate documentation and supervisory controls to
assure that these allocation procedures are being
followed consistently.

2. Allocation Plans

Exchange rules require each member firm to file with the various
options exchanges its plan for allocating exercise notices to its
customers and to make these plans available for review by customers.
Despite the straightforward requirements imposed by these exchange rules,
brokerage firms sometimes circumvent or ignore the requirements. Conse-
ouently, both the AMEX and CBOE have had to caution numerous firms for
failure to submit their plans for approval or for failure to follow
their declared allocation procedures once approved.

Among the allocation methods approved by the exchanges are a random
selection basis, a " first-in, first -out" basis, variations of these method;
to distinguish between "block-size" orders and individual orders, and
other methods deemed fair and equitable to the member firm's customers.
Of the industry group sample, 62 percent used variations of the

481

random selection allocation methods; 36 percent used " first-in, first -out"
allocation methods; and 2 percent of the industry sample used other methods,
There seems to be a trend throuqhout the industry toward random
selection and away from "first-in, first -out" allocation methods. Each
method has advantaqes and certain regulatory problems arise from each,
a. Random selection methods

Althouqh the sophisticated samplinq techniques of certain random
basis allocation systems provide a high degree of objectivity, the
complexity and lack of uniformity of such methods can impede firms and
regulators in conductinq prompt and effective audits. Reconstructing
how exercise notices were allocated during even one expiration period
is sometimes difficult.

Of qreater concern to the Options Study, however , are the informal
random basis allocation systems. A senior officer of one firm, for
instance, described his firm's allocation method as the "flip of the
coin" method. The employees of another firm explained how that firm
used "a random draw" allocation method as follows: they created "named
sliDs" for each short contract in a given customer's option position,
rooled those slips, and then engaged in a drawing to determine the
allocation of exercise notices.

The most prominent weakness of these informal exercise allocation
svstems is the absence of workpapers or other documentation to verify
that the allocation process was accomplished in a manner fair and equitable
to Dublic customers. In addition, in several cases, brokerage firms had

482

no supervisory procedures which described even the informal procedures
that the firm purported to follow. These circumstances provide little
assurance that allocation methods will be consistently or equitably
applied from one expiration date to the next.

b. "First-In, First-Out" (FiFo) systems
In a FiFo allocation system, the first customer to be assigned
an exercise notice in an options series is the customer who first
wrote a still-open contract in that options series. Although straight-
forward FiFo systems are easily understandable and verifiable by audit,
FiFo systems generally work to the disadvantage of longer term options
investors who are more likely to be exercised than customers with
more recently established positions.

In addition, some brokerage firms use variations of the FiFo allocation
system which favor the active or large account or which are otherwise
inconsistent with exchange requirements that such systems be "fair and
eaui table" to customers. Both the CBOE and the AMEX repeatedly have
cautioned firms against the use of FiFo systems which do not assure
that the customer who first writes an option will be assigned an exercise
first reaardless of other subsequent activity in the account. Nevertheless,
several firms still use modified FiFo systems which provide that any
activity in an account subsequent to the trade date automatically updates
that account's "first- in" date to the date of the most recent activity.

483

Such a modification reduces the risk that exercise will fall upon the

more active and larqer account while increasing the risk of exercise

for the smaller or less active account.

Exercise allocation methods must be fair and equitable to

the public customer. Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
AMEND THEIR RULES TO REQUIRE MEMBER FIRMS
TO PROMPTLY ADOPT A UNIFORM METHOD FOR
THE RANDOM ALLOCATION OF EXERCISE NOTICES
AMONG CUSTOMER ACCOUNTS.

3. Audit Trails

The most pervasive weakness in the process of allocating exercise
notices is the lack of an audit trail, that is, of workpapers, records,
or other documentation which enable supervisors and regulators to verify
that an approved exercise allocation plan has been followed. Since
certain firms do not maintain adequate documentation to explain
the operation of their allocation methods, some supervisors express
confusion about the exercise allocation procedures they are supposed
to control. Other firms have no records to verify that the procedures
they purport to use have, in fact, been applied.

The experience of one large regional brokerage firm demonstrates
many of the weaknesses associated with this lack of an audit trail
for exercises allocations. Although the compliance officer of the firm
told both NASD and Commission inspectors that the firm used a FiFo method
of exercise allocation, analysis of customer accounts which had been

484

assigned exercise notices during several expiration periods disclosed
numerous deoartures from any known FiFb method of allocation.

In the ensuing investigation, employees of the firm gave con-
flicting testimony about the procedures followed by the firm in
allocating exercise notices among customers. Both the firm's president
and compliance officer testified that they believed the firm employed
a FiFo system. The margin clerk, however, testified that his supervisors
had instructed him to employ the FiFo system unless an assignment would
affect one of the customers of the firm's head options trader. In
that case, he was to inform the head options trader of the customer
accounts having positions which could be exercised, after which he
would receive a list of customer accounts designated to receive exercise
notices. The margin clerk testified about the problems that arose
when he initially attempted to use the FiFo method:

After I notified [the head trader] of the
assignments, I proceeded to work on that
method by assigning the customers the
options that were first in. And apparently
[the head trader] did not like the assignments
as I related them to him, and spoke to
[the sales manager] who in turn called
my boss, who was operations manager, and
I was told by my boss to go along with
whatever assignments they wanted.

The firm's options trader insisted that he merely served as a

conduit for information between the margin clerk and the sales manager

of the firm. In contrast, the sales manager testified that he personally

allocated all exercise assignments on a random basis, using an

485

undocumented lottery method in which he blindly selected slips of
paper reDresenting customer positions. An analysis of customer options
accounts, however, revealed that certain customers consistently sustained
large losses from untimely exercises while other customers consistently
avoided exercise. Most of the accounts assigned exercise notices were
those of long time customers with large account equity who could bear
the losses resulting from exercise better than smaller accounts serviced
by younger salesmen .

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
REQUIRE MEMBER FIRMS TO KEEP SUFFICIENT
SPECIFIC WORKPAPERS AND OTHER DOCUMENTATION
RELATING TO ALLOCATIONS IN PROPER ORDER
SO THAT A FIFM'S COMPLIANCE WITH THE UNIFOPM
EXERCISE ALLOCATION SYSTEM CAN BE VERIFIED
PROMPTLY FOR AN APPROPRIATE PERIOD OF
TIME.

CHAPTER VI
SELF-REGULATORY ORGANIZATION OVERSIGHT
OF RETAIL FIRMS AND THEIR ASSOCIATED PERSONS
I. INTRODUCTION

The self -regulatory organizations ("SROs" ) are required by law to
oversee the conduct of their member broker-dealer firms and to impose
sanctions on those firms and their associated persons when violations
of the law or SRO rules are detected. This chapter primarily addresses
SRO efforts to enforce member firm compliance with rules which relate
to retail sales practices. Certain other SRO activities pertaining to
the oversight of broker-dealer firms, such as the registration of sales-
persons and the monitoring of financial and operational developments,
are also discussed.

The Commission's release announcing the commencement of the Options
Study noted the Commission's concern that lapses in "regulatory programs
by options exchanges to detect and deter [selling] practices [abuses] are
more serious than the Commission had earlier perceived" 1 /, and
directed the Options Study to review, among other things, "the ability
of self -regulatory organizations to enforce compliance by brokers and
dealers with appropriate selling practices [rules] regarding standardized
options." 2 /

As a first step in analyzing the effectiveness of SRO sales practice
compliance programs, the Options Study asked each options exchange to

!_/ Exchange Act Release No. 14056, p. 25 (October 17, 1977).
2_/ Id. at 27.

(487)

488

submit a detailed description of its compliance program. 3 / Similar
requests were made of the NYSE and NASD. 4 / After analyzing these
submissions, the Options Study conducted on-site inspections of
the AMEX, CBOE, NYSE, PHLX and PSE to obtain a better understanding
of their compliance programs and to determine the manner in which
each SRO followed the procedures that it had described in response
to the Options Study's request. 5 / During these on-site inspections,
the Options Study reviewed SRO compliance files and interviewed
selected SRO compliance personnel. Cumulatively, the Options Study
reviewed approximately 1,200 routine options examinations which had
been conducted by the exchanges and approximately 300 options related
cause examinations and related disciplinary actions. 6_/ In addition,
approximately 75 interviews were conducted with SRO compliance personnel.

3 / Appendix A.

4 / Appendices B and C.

5 / This chapter does not include compliance programs of the MSE or NASD,

unless otherwise noted. The MSE's submission to the Options Study
was submitted in a form that was not usable. Despite the Options
Study's requests to remedy that problem, the MSE did not do so. The
NASD's submission arrived too late to be included in all phases of
the Options Study's analyses.

6 / For a description of routine and cause examinations, see pp. 11-14,

infra.

489

The Captions Study found serious shortcomings in tne SROs' selling
practice compliance programs. While the severity of the problems
varied among the SROs, the Options Study identified several deficiencies
which are common to the programs of all SROs. In summary, these

are:

(1) SROs in their compliance activities fail to collect and use
available information, in that -

- the SROs frequently fail to seek out and question
public customers when inquiries of such customers
might be useful in their examinations and investi-
gations of member firms and their salespersons

- the SROs generally do not share among themselves their own
compliance data

- the SROs do not attempt to obtain useful compliance infor-
mation which is available from government agencies

- the SROs do not make adequate use of information available
at member firms

(2) SRO procedures for examining and investigating their members
are deficient, in that -

- examinations find procedural and record-keeping pro-
blems but are not adequately designed to find sub-
stantive violations such as fraud, excessive trading,
and unsuitable recommendations

- investigations too often focus narrowly on a specific
episode or problem and fail to ascertain whether the
specific matter is part of a broader pattern of abuse

(3) SRO disciplinary proceedings often are ineffective to deter
future violations in that SROs frequently -

- use informal sanctions for serious violations

- allow repeated violations to continue without deci-
sive remedial action.

In describing these problems in the following section of this

chapter, illustrative cases are provided. It might be useful at this

490

point, however, to mention one firm's compliance history since 1973
(summarized in Appendix D) which seems to illustrate a number of
these problems.

In the course of their 32 options related examinations and
investigations of this firm during this period, the AMEX, CBOE, NASD
and NYSE did not collect and evaluate available compliance data
(including, information about examinations and investigations con-
ducted by each other), did not conduct sufficiently thorough inquiries,
did not coordinate their compliance efforts, and failed to detect
apparently serious selling practice abuses in this firm. Moreover,
even when violations were noted, the disciplinary action taken by
the SROs was ineffective in motivating the firm to cease its improper
practices and initiate effective remedial action because, as shown in
Appendix D, the firm continued to violate the same or related SRO
rules. The Commission's staff undertook an inquiry of this firm
in 1977, and found apparently serious violations of the antifraud
provisions of the federal securities laws and failures by the firm
to supervise adequately certain salesmen.

During the Options Study's interviews, SRO officials have offered
two explanations for these systemic deficiencies. First, these officials
acknowledge that, because of their preoccupation with the problems
which emerged from the establishment and rapid expansion of the
new options markets, the exchanges did not devote adequate attention

491

to selling practice compliance activities. Second, the SROs generally
concede that they concentrated on their individual self-regulatory
obligations without recognizing the regulatory needs of other SROs
and the importance of other SROs' regulatory efforts to their own.

To remedy these deficiencies the Options Study's principal
recommendations are that tne SROs: (1) broaden the scope of their
investigations and examinations and routinely question public
customers when necessary to determine whether there may have been
a violation of the federal securities laws or SRO rules, to resolve
disputed issues of fact, or to verify information obtained from
another source; (2) develop ways to better share information and
allocate responsibility, including the establishment of a central
repository of information concerning common member firms and their
employees; (3) establish industry-wide minimum standards and procedures
for conducting their compliance programs; (4) restrict informal disci-
plinary actions to cases in which public customers have not been injured
and in which rule violations are minor or isolated; and (5) amend their
rules (if necessary) to permit restitution to be awarded to injured
investors as a remedial sanction in appropriate enforcement cases.

Many of the Options Study's concerns were brought to the attention
of the SROs at a meeting held with the members of the Options Study
staff in August, 1978. 7_/ Thereafter, the SROs in a series of meetings;

7 / See Chapter TV.

492

informally referred to as the Self -Regulatory Conference, 8 / agreed,
among other things, "to review current industry compliance practices
toward the goal of developing a more standardized compliance program"
and "to review the feasibility and usefulness of creating a central
repository for compliance information." The Options Study believes that
the proposals under study by the SROs are a good first step in developing
solutions to remedy many of the problems identified in this chapter.
II. AN OVERVIEW OF SRO COMPLIANCE PROGRAMS

Before reviewing the problems in SRO sales-practice compliance
programs, it is useful to have an overview of such programs. While each
SRO's program has certain unique features, there are some features which
are common to all. SROs have monitoring programs, conduct cause examina-
tions and routine examinations, and have procedures for imposing
disciplinary and other remedial sanctions. 9 /

A. Monitoring programs

There are five monitoring programs which have relevance to member
firm oversight: (1) regulation of the employment and termination
of employment of registered representatives; (2) review of customer
complaints; (3) review of member firm advertising; (4) oversight of

8_/ See Chapter IV.

9 / In sane instances, however, SROs have allocated responsibility among
themselves for the administration of certain programs. See pp. 30-32,
infra .

493

the financial and operational condition of retail firms; and (5) control
of extensions of credit to public customers.

1. Employment and termination of registered representatives:
The SROs are required to prevent their members from employing, without appro-
priate authorization, individuals who have been prohibited from selling secu-
rities because they have been found to have violated the federal secu-
rities laws or certain other statutes or rules as specified in the
Exchange Act 10/, or who are subject to a "statutory disqualification" as
defined in the Exchange Act. 11/ In addition, each SRO has specified
qualification standards for registered representatives which include the
passing of certain qualification examinations. 12/ As an initial step in
the qualifying process, an applicant must apply for registration with the
SROs to which his prospective employer belongs. The standard application
form used by the SROs requires the applicant to respond to questions about
his background and employment history, and to state whether he is currently
the subject of any investigation by an SRO, the Commission, or other securities
regulatory bodies. Through this registration process, SROs should be able
to identify those individuals who may require special supervision by the
employing firm, or who should be excluded from the securities. business.

10/ See Section 15(b)(4), 15 U.S. C. 78o(b)(4).

11/ See Section 3(a) (39), Exchange Act, 15 U.S.C. 78c(a)(39); see also

Sections 6, 15(b) and 15A of the Exchange Act, 15 U.S.C. 78f, 78o(b),
and 78o-3.

12/ For a discussion of these examinations, see Chapter V.

40-940 O - 79 - 34

494

When a salesperson leaves a firm, the firm is required to notify
each SRD of which it is a member so that the salesperson's registration
with the SRD may be cancelled. SROs require these termination notices
to specify the circumstances of termination, including whether the
salesperson was fired because he violated a provision of the securities
laws or an SRD rule, is or has been the subject of a customer complaint,
or has been named as a defendant in a civil action for alleged violations
of the securities laws. The SRD compliance staffs believe that termination
notices aid significantly in detecting potential problems.

2. Customer complaints; Some securities customers complain
directly to the SRDs about problems they have experienced as well as to
the brokerage firm and the Commission. During 1977, the options exchanges
and the NASD received approximately 750 customer complaints, of which
approximately 150 involved options related selling practice problems.
Only the NYSE requires its members to forward to it a copy of all "major
complaints" the members receive. 13/ SRDs have procedures to review
customer complaints which they receive directly or by referral from
other SROs or the Commission. In addition, most SRD examinations include
a review of the firm's complaint files or customer correspondence files.

3. Advertising; Tne SRDs have adopted standards governing
their members' advertising with respect to options. To help ensure that
misleading options related advertising is not used in violation of these

13/ NYSE Rule 351(c). For a discussion of this reporting requirement ,
see pp 38 - 40, infra.

495

standards, tne options excnanyes require their members to submit
options related advertising to them for review and approval prior to
use. 14/ borne bROs relieve their members of tne obligation to submit
options advertising tor clearance prior to release if the advertising
nas oeen approved d/ anotner bRU. 15/ In addition, there are informal
agreements oetween or among bROs oy which one bRO may review advertising
on oenait ot otner bROs.

Utner sales literature, such as marxet letters that contain analyses,
reports, recommendations, or comments on options, is not required to be
tiled with an bRO prior to distrioution. All bRO procedures call for
a review ot Doth options advertising and options sales literature as
part ot tneir routine examinations of member firms. The CBOE is the
only bHJ, nowever, whicn reviews sales literature throughout the year
even wnen tnere is no routine examination, Each week the CBOE staff

14/ bee also Chapter V. The amEX, CBOE, MSE and PHLX have filed with
tne Commission proposed rule changes which, if approved, would
estaoiisn uniiorm standards for the review of options sales
literature, bee bR-AMEX-1978-21, 43 Fed. Reg. 50512 (Oct. 30,
1978); bK-CbOE-1978-26, 43 Fed. Reg. 50515 (Oct. 30, 1978); bR-
NbE-1979-1 (unpublisned); bR-PHLX-1978-21, 43 Fed. Reg. 52795
(Nov. 14, 1978). The Commission's staff has been informed that
tne PbE intends to suomit similar proposed rule changes, but
as ot January 20, 1979, such proposals have not oeen filed with
tne Commission.

15/ Tne NAbU requires that member firms file proposed options advertising
with tne Association. Unless tne NAbD staff objects to the proposed
advertising witnin 10 days, the firm may release it. At the NYbE,
member firms are not required to obtain NYbE approval before issuing
advertising, althougn NYbE firms are required to adhere to certain
NYbE advertising standards.

496

selects several firms and requires those firms to submit all of their
options sales literature for a particular month for review by the staff;
each CBOE firm is selected for review twice a year.

4. Financial responsibility early warning systems; To
assure that retail firms are in compliance with applicable net
capital, margin and similar requirements, every firm is required to
make confidential periodic filings with an SRO disclosing information
on its financial condition and significant operational developments.
To avoid unnecessary duplication, the Commission has allocated re-
sponsibility for reviewing these filings among the SROs, and requires a
firm to file its financial reports only with the designated SRO. In
addition, a firm is required promptly to notify the Commission and the
designated SRO whenever its financial condition reaches certain pre-
scribed levels or its operational responsibilities are impaired. 16/

At least once a year, the designated SRO makes an in-depth ex-
amination of each retail firm's financial and operational condition.

5. Credit monitoring; Federal law requires purchasers of
securities to pay for their cash purchases within a specified time period,
but permits retail firms to apply for and receive on behalf of a customer
fran an SRO an extension of the payment date for "exceptional circum-
stances". Applications for extensions of time ("Regulation T

16/ See 17 CFR 240, 17a-ll; See also Chapter VII.

497

requests") may be filed with an appropriate SRO. SROs prefer, however/
that applications be filed with the SRQ which has been designated to
process the firm's financial reports.

Each SRO has its own system for processing Regulation T requests.
All SROs, except the NYSE, process complaints manually. The NYSE, which
receives about 450,000 requests per year (more than any other SRO), uses
a computer to process and, in most instances, grant automatically

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